United States: Does Washington's Capital Gains Excise Tax Reduce Taxable Gain?

As many of our readers know, the Washington Supreme Court recently validated the state's new excise tax on the sale or exchange of long-term capital assets (the LTCAET)as a constitutional excise tax on the privilege of selling or exchanging certain capital assets. The tax is commonly, but perhaps incorrectly, referred to as the "Washington capital gains tax." In this article, we refer to it as the LTCAET to emphasize the Washington Supreme Court's determination that the tax is an excise tax, even though the amount of tax is generally measured by net federal long-term capital gains allocated to Washington state. (We sincerely hope someone more creative than we are will come up with a more mellifluous acronym than LTCAET).

Elsewhere we have written about the Supreme Court's decision and the operation of the LTCAET.As relevant to this article, we note that (1) the Washington Supreme Court specifically rejected the Superior Court's holding that the LTCAET was an income tax, and (2) the LTCAET does not apply to the sale of real property. Regardless of whether we accept the logic of the court, we have to respect the authority and wisdom of the Washington Supreme Court, at least until the U.S. Supreme Court tells us otherwise.

Many of our readers also know that an individual's federal tax deduction for non-business state and local taxes is capped at $10,000. IRC § 164(a)(6). We have written about the Oregon workaround for this cap, which is consistent with the approach taken by other states. Washington does not have such a workaround so, for virtually everyone subject to the LTCAET, the tax is not deductible when computing federal taxable income (because most people subject to the LTCAET likely reach the $10,000 cap based on income, property, or sales taxes).

However, this does not mean that all hope is lost on obtaining a federal tax benefit for the LTCAET. We believe a reasonable position exists to treat the LTCAET as a capitalized cost of sale that reduces federal capital gains. Thus, the LTCAET may reduce a taxpayer's federal capital gains, even if it cannot reduce the taxpayer's federal ordinary income.

In upholding the status of the LTCAET as an excise tax rather than an income tax, the Washington Supreme Court drew an analogy to Washington's real estate excise tax (REET).For example, as part of upholding the LTCAET, the Washington Supreme Court, referring to the REET, stated: "[t]hough that tax clearly concerned property, we held it is a valid excise because it taxes the sale of property." Quinn v. State, 526 P.3d 1, 14 (2023) (emphasis added).

The REET is, of course, treated as a cost of sale that reduces the amount realized - which reduces federal capital gains (or increases the capital loss) from the sale. Treating the LTCAET as a cost of sale like the REET seemingly opens the door to similar treatment with respect to reducing gain. After all, the REET is "imposed [as] an excise tax upon each sale of real property." RCW 82.45.060. The LTCAET is "an excise tax [] imposed on the sale or exchange of long-term capital assets." RCW 82.87.040(1). Or, in the Washington Supreme Court's words, each "taxes the sale of property," with the REET and the LTCAET simply being excise taxes on the sale of different properties. If the REET reduces federal capital gains from the sale of the type of property subject to the REET (real property), the LTCAET ought to reduce federal capital gains on the sale of the type of property subject to the LTCAET (long-term capital assets) even though the LTCAET is measured very differently.

Of course, the federal tax characterization of a tax and the timing of a deduction does not always comport with the state's characterization and payment schedule of the state tax, so there are potential issues to consider before claiming the LTCAET as a cost of sale in the year of the sale:

• IRS Treatment: The IRS could disagree with the Washington Supreme Court and find the LTCAET to be a tax on net income rather than an excise tax on the privilege of sellingcapital assets. That is effectively the argument we unsuccessfully advanced to, and which was resoundingly rejected by, the Washington Supreme Court. But the IRS certainly could apply the substance over form doctrine and determine that, regardless of the status of the tax for Washington tax and constitutional purposes, the LTCAET should be characterized as an income tax for federal income tax purposes. After all, the LTCAET "looks, swims, and quacks" like other state net income taxes imposed on capital gains. Taxpayers could, of course, counter such an IRS position by pointing out that both the Washington legislature and the Washington Supreme Court have carefully and thoroughly interpreted this Washington law and the IRS should not be able to ignore such authority and the quality of their reasoning.

Historically, the U.S. Tax Court has looked to state interpretation when determining the deductibility of Washington REET. Though not precedential, in Steven v. C.I.R., T.C. Summ. Op 2004-100, 2004 WL 1663400 (July 27, 2004), the court found that any tax that does not fall within one of the specific categories of deductible taxes enumerated in IRC § 164(a) and that is paid or accrued in connection with the disposition of property, shall be treated as a reduction in the amount realized on the disposition of that property. Id at 2. The court looked to Washington state law to determine whether the REET was a "real property tax" for federal income tax purposes. Id at 3.

After reviewing the REET statute, it was clear to the court that the nature and character of the tax at issue was that of an excise tax, because it is imposed on the "transaction or particular privilege of selling real property." Id. Transaction privilege taxes concerning the transfer of property are not deductible under IRC § 164(a) because "such taxes are not imposed on interests in property." Id. Instead, they are a reduction in the amount realized on disposition pursuant to the flush language of IRC § 164(a) discussed immediately below.

There is also some relatively recent, but also non-precedential, IRS guidance that supports respecting the LTCAET as an excise tax. In CCA 201531016, the IRS held that Washington's cannabis excise tax should be treated as a reduction in proceeds on the sale of property for federal income tax purposes based on the last sentence of IRC§ 164(a), which provides:

[A]ny tax.which is paid or accrued by the taxpayer in connection with an acquisition or disposition of property shall be treated as part of the cost of the acquired property or, in the case of a disposition, as a reduction in the amount realized on the disposition.

The cannabis excise tax was levied on the selling price of each retail/wholesale sale of cannabis, and not on net gain.

The CCA from the IRS Office of Chief Counsel also noted that "there could be an issue of whether economic performance has occurred if a taxpayer who uses an accrual method of accounting has not paid the cannabis excise tax. See Treas. Reg. § 1.461-4(g)(6)" [a timing issue we address below].

Similarly, in Rev. Rul. 80-121, the IRS held that Vermont's "land gains tax" on the sale or exchange of land was a transfer tax and not an income tax. The IRS emphasized that taxpayers are allowed to reduce gains by losses for federal income tax purposes. However, Vermont taxpayers are unable to reduce taxable land gains by losses (meaning a taxpayer could be subject to the Vermont land gains tax without owing federal income tax if the taxpayer also had losses from other property). Therefore, the tax was not considered an "income" tax. This ruling could also be used offensively by the IRS to assert that LTCAET more closely resembles an "income tax" because it is assessed on net long-term capital gains from all gains allocated to Washington. Should the IRS successfully advance such a position, the IRS could argue that the LTCAET does not reduce the amount of federally taxed gain recognized on the disposition of capital assets.

Should the IRS challenge the characterization of the LTCAET as an excise tax, query whether a federal court reviewing such an IRS position would be more likely to respect the analysis and conclusion of the Washington Supreme Court. See, Commissioner v. Estate of Bosch, 387 U.S. 456 (1967) (no deference is given to state court decisions in interpreting a federal law, but when the substantive rule involved is based on state law, then the State's highest court is the best authority if they've ruled on the matter).

• Circular Computation: As described above, the measure of the LTCAET is long-term federal capital gains shown on the federal return (subject to numerous adjustments we explain in our other article). If the LTCAET reduces federal capital gains as a cost of sale in the year of sale, then the calculation of the taxpayer's capital gains and LTCAET become an interrelated calculation. To illustrate: the amount of capital gain determines the amount of the LTCAET; the amount of the LTCAET so determined reduces the amount of capital gains; then the amount of redetermined capital gains affects the amount of LTCAET; and so on. The amounts of capital gain and the LTCAET can be determined using iterative (or circular) calculations. Simply ignoring the circularity of the equation creates its own problems as the amount of the federal gain offset probably should be capped by the actual amount of the LTCAET imposed on the transaction generating the gain, not the 7% statutory rate.
  
• Timing: Excise taxes imposed on the sale of long-term capital assets, such as the Washington excise tax imposed on sales of real estate, aretreated as costs of the sale that reduce the seller's capital gain or increase capital loss. If the LTCAET is an excise tax imposed on the sale of certain capital assets in Washington, then clearly it should also be treated as a reduction in the amount realized from the sale similar to other costs of sale. The question becomes when and how that cost of sale is properly claimed.
  

However, the tax return for the LTCAET is due on or before the due date of the taxpayer's federal income tax return, not at the time of sale. In the ordinary course of tax reporting, a taxpayer may wait until the due date of the return to compute and pay the tax. Almost always, individual taxpayers file calendar-year tax returns applying the cash method of accounting. This creates a potential mismatch in tax years between the tax year in which the capital gain is recognized by the taxpayer and the tax year in which LTCAET is paid or accrued. Taxpayers and their advisors must evaluate their options to avoid mismatched tax years including the viability of any plan to pay the excise tax and file the LTCAET return in the same tax year in which the related capital gains was recognized.Taxpayers might also consider whether there is a reasonable basis for arguing that the excise tax is validly accrued for a taxpayer in the year in which the capital gain was recognized triggering the tax liability. Taxpayers should be counseled of potential headwinds from the Washington Department of Revenue and Internal Revenue Service until the tax advisors and tax collectors gain experience filing and paying taxes under LTCAET. If the payment of the LTCAET is determined to be made in a year different than the year in which the capital gain was recognized, the taxpayer nevertheless should be entitled to a long term capital loss deduction in the year the tax is paid. See, e.g., Arrowsmith v. Commissioner, 344 U.S. 6 (1952), Shannonhouse v. Commissioner, 21 TC 422 (1953).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.