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Noonan’s Notes Blog is written by a team of Hodgson Russ tax attorneys led by the blog’s namesake, Tim Noonan. Noonan’s Notes Blog regularly provides analysis of and commentary on developments in the world of New York and multistate tax law. Noonan's Notes Blog is a winner of CreditDonkey's Best Tax Blogs Award 2017.

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Washington State Capital Gains Tax Struck Down by Judge As Unconstitutional

On Tuesday, March 1, 2022, Washington State Superior Court Judge Brian Huber released a ruling striking down the state’s new capital gains tax. The law—signed by Governor Jay Inslee last May—imposes a 7% tax on the sale of stocks, bonds, and other assets above $250,000. When signed, Washington became the first state in the country with no income tax to impose a tax on capital gains.

Judge Huber—who was appointed by Governor Inslee in 2019—held that the tax “violates the uniformity requirement by imposing a 7% tax on an individual’s long-term capital gains exceeding $250,000;” however, zero tax is imposed on capital gains below that threshold. Judge Huber rejected the state’s argument that the tax was actually an excise tax, and instead found it was properly characterized as an income tax. And while an excise tax could be constitutionally permissible in Washington, the state constitution prohibits singling out certain types of property for a special tax. The judge concluded that this law created a tax on property—“as a tax on the receipt of income [the tax] is also properly characterized as a tax on property,” pursuant to case law in Washington state.

In his ruling, Judge Huber listed several more reasons why the tax should be characterized as an income tax. For one, the tax relies on federal income tax returns, and the Internal Revenue Service has characterized long-term capital gains as income. Additionally, the tax would be imposed annually, like an income tax, as opposed to at the time of each transaction, which is how an excise tax functions.

The ruling was a blow to state lawmakers who adamantly defended the tax in court, but this ruling, while significant, does not mark the end of the line for this tax. Washington Attorney General Bob Ferguson already came out publicly against Judge Huber’s ruling, and stated the state will appeal the ruling all the way to the state Supreme Court, if necessary. The state relied heavily on public policy arguments about the benefits this tax would have on the state: increasing funding for education and furthering a fairer tax system, among other things. But Judge Huber wrote that he must first consider the substantial Washington case law on this issue, which was overwhelmingly opposed to the legal arguments put forth by the state.

In contrast, the outcome is a big win for taxpayers in Washington. The imposition of a 7% tax on capital gains is not inconsequential considering many taxpayers move to Washington because of their lack of income tax. Of course, the state will continue litigating the validity of the tax. And if they are successful, Washington state officials should be prepared for the possibility that many taxpayers may move to a state with more taxpayer-friendly laws. A sight that New York State’s legislators are all too familiar with.

But the plaintiffs explained they are confident that the strength of Judge Huber’s ruling will help their position in the appeals to come. And the plaintiff’s position is based strongly on Washington case law and their Supreme Court’s interpretation of the state constitution. That court has long opposed any tax that resembles a tax on the income of persons or corporations. Notably, the plaintiffs put forth federal constitutional issues that Judge Huber did not address. Specifically, they argued this tax conflicts with the U.S. Constitution’s commerce clause. On appeal, those federal constitutional issues could provide additional arguments against the imposition of the tax.

For now, taxpayers in Washington can breathe a sigh of relief. We’ll monitor the status of this litigation as it progresses to the appeals stage and notify our readers of any significant updates, so keep an eye on the blog.

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