The state Supreme Court heard oral arguments on January 26, 2023, concerning the capital gains income tax. The income tax is first owed by April 18, 2023. The Department of Revenue has already launched an online portal for taxpayers to pay the tax. We previously posted on the three possible outcomes from the lawsuit. To help explain some of the questions that the justices asked during oral arguments, I had the opportunity to interview two of the lead attorneys in the case, Callie Castillo and former Attorney General Rob McKenna. Here is my exchange with those attorneys.

Last week you were the attorneys arguing before the Washington Supreme Court on behalf of the plaintiffs who overturned the new state capital gains income tax in Superior Court. Based on the justices’ questions regarding the constitutionality of the tax, what do you think are the main issues they are considering?

Castillo: “The Supreme Court is considering whether the new capital gains tax is an excise tax, as the State claims it is, or an income tax, as the Superior Court held it to be. If it’s an income tax, it’s unconstitutional because income is property under Washington’s law, and it exceeds our state constitution’s limits on property taxes. If the Supreme Court rules that it’s an excise tax, it’s still unconstitutional because it taxes gains from anywhere in the country or world, beyond Washington State’s jurisdiction, in violation of the federal commerce clause.”

McKenna: “That’s exactly right. The Court was also considering arguments by a group of intervenors in the case, who argue that if it is an income tax, the Court should uphold it anyway by overturning nearly a century of its own precedents – many, many decisions by the Court finding that income is property under our constitution’s exceptionally broad definition of property as everything, tangible and intangible, subject to ownership.”

The Attorney General’s Office (AGO) repeatedly referred to the Business & Occupation tax, Real Estate Excise Tax, and Estate Tax as examples for why the court should find the capital gains tax is an “excise tax” instead of an income tax. Why are these analogies wrong?

Castillo: “All of these are true excise taxes: they are imposed when a taxpayer voluntarily engages in a transaction that is possible because the State has created or extended a particular privilege under its laws. The B&O tax is imposed on the privilege of operating a business in our state; the REET, on sale and transfers of real property within Washington; and the estate tax on the privilege of transferring title to the estate’s assets to designated heirs.

The capital gains tax, in contrast, is not imposed on any privilege granted by the State. The right to receive capital gains income is not a substantive privilege created by any government and therefore is not subject to an excise tax. Everywhere else in our country, capital gains are taxed with an income tax because, of course, every other jurisdiction sees them as income.

In addition, Washington is trying to tax capital gains generated outside of the state with its ‘excise tax’ but simply does not have jurisdiction to do so.

Finally, we have pointed out to the Court that this tax is not an excise because the State wants to impose it even where the triggering event that produces a capital gain is not voluntary – such as the sale of a company in which shareholders who did not ask for or approve the sale recognize a gain through no action of their own.”

McKenna: “Our Supreme Court has always said that it doesn’t matter what label the legislature gives a tax. It’s the judicial branch that decides what kind of tax has been created. Courts do this by determining the ‘incidence’ of the tax: what triggers it, what does it apply to? The statute creating the new capital gains tax states that the ‘tax applies when the Washington capital gains are recognized by the taxpayer,’ as reported on their federal income tax return. So the incidence of this tax, according to the legislature and the Superior Court, is the recognition of capital gains. If the sale or exchange of a capital asset doesn’t result in a gain, it isn’t taxed. That’s because unlike the REET, for example, the triggering event isn’t the asset’s transfer, it’s the recognition of income. Hence, it’s an income tax.”

During oral arguments, didn’t the State claim that the new tax can reach gains generated outside Washington because the Supreme Court has already upheld Washington’s inheritance tax and (more recently) its estate tax, which reach intangible assets outside the state?

McKenna: “The State did make that argument but, as we had already explained in our briefing to the Court, it’s mistaken. First, as noted above, the State has not created or extended any privilege that can be taxed with an excise to reach capital gains. The estate tax, and its predecessor inheritance tax, are and were excises on the privilege of transferring title in the estate’s assets to the heirs. In addition, unlike the capital gains tax on both legal and beneficial owners of capital assets, the estate tax can always be avoided – it’s the result of a voluntary action, in other words – by allowing the estate’s assets to escheat to the State, or by the decedent choosing to give away most or all her assets at death.”

Castillo: “That’s right. Furthermore, estate taxes are apportioned: any estate taxes paid on assets in other states offset or reduce the estate taxes owing in Washington, so there’s no risk of multiple taxation. The capital gains tax is not fairly apportioned, and taxpayers run the risk under the new statute of being taxed twice on the entirety of their income from a sale or exchange, such as if they are resident in more than one state. The Legislature failed to incorporate any principles of apportionment in the statute so that the capital gains tax is constitutionally imposed only on that portion of income reasonably attributed to the taxpayer’s in-state activities in connection with an asset’s sale or exchange. This is what doomed the original version of Washington’s B&O tax which was struck down by the U.S. Supreme Court because it was based on gross revenues that included receipts from sales in interstate commerce, without apportionment.”

What were some of the justices getting at with their questions about the plaintiffs’ “facial” challenge to the capital gains tax, and the “standard of review” that the Court should apply?

Castillo: “Remarkably, the State is arguing that even if Washington’s capital gains tax unconstitutionally attempts to reach gains recognized from transactions outside the state, it should still be upheld by the Court if the tax is held to be an excise, not an income tax. They say it’s okay for an excise tax to partially be unconstitutional so long as there are situations where it can be imposed legally within Washington. That’s simply not true. The U.S. Supreme Court struck down our state’s first B&O tax as unconstitutional on its face because it taxed a company’s gross receipts from outside Washington as well from within our state. The Legislature had to start over and reenact the entire law the year after the original B&O tax was struck down. It did not matter that there could be some situations where the tax could be applied constitutionally – such as when a business only had revenues from activity within Washington.”

McKenna: “The standard of review applied by an appellate court in case like this one is referred to as ‘de novo’ – from scratch, you might say. That makes sense, because our state Supreme Court is the supreme authority for interpreting our state constitution and laws. Here, we have nearly 100 years of Supreme Court decisions finding that, under the plain meaning of our constitution’s all-encompassing definition of property, income is property. That doesn’t mean an income tax per se is prohibited; it just means that income must be taxed according to the constitution’s requirements for property taxes: it must be uniform, and no higher than 1% per year.

For Washington to adopt a progressive income tax, either in the Legislature or by popular initiative, the Supreme Court has repeatedly held that another amendment to the constitution is required. In fact, that’s been attempted six times! Washington’s voters have been presented by supermajorities in the Legislature with six proposed amendments over the years that would change the constitution’s definition of property to allow for a graduated tax on income. The voters have said ‘no’ every time, by wide margins.

It’s also important to point out that ‘income as property’ isn’t the only area where our Supreme Court has decided what the law is. The Court has also repeatedly held that for a tax to be an ‘excise,’ it must be voluntary and avoidable, and must be based on a privilege created or extended to all of us by the State. Those two tests simply are not satisfied by the capital gains tax. At the same time, those elements are not required for (you guessed it!) an income tax. It’s another way we know that the new tax is on capital gains income, not on a privilege voluntarily exercised by certain taxpayers.”

During closing arguments, the AGO said that 41 other states have capital gains taxes and that they don’t violate the commerce clause so neither would Washington’s. Why is it ok for the other states to tax capital gains as an income tax but an “excise tax” on capital gains would violate the commerce clause?

McKenna: “That’s a bit of rhetorical sleight of hand. The other states tax capital gains because they have (you guessed it again!) state income taxes. Literally no other taxing jurisdiction in America, from the federal government on down, applies an excise tax to capital gains, because capital gains are a form of income, not the product of an avoidable, voluntary action of taxpayers who are exercising a state-granted privilege.”

Castillo: “Exactly right.”

The last request the AGO made to the court was to expedite their ruling. This resulted in an interesting comment from one of the justices pointing out that the AGO previously requested (and was granted) a stay of the Superior Court ruling finding the tax unconstitutional so that the state could collect the tax now. What did you think of this exchange and what does it mean for the possible timing of a ruling?

Castillo: “There’s no way to know for certain, of course, but it could mean that the Court plans to take the time it needs to decide this case, and not be rushed to judgment. The Department of Revenue has announced that capital gains taxes it collects under the new statute will be refunded if the Supreme Court upholds the Superior Court’s ruling and strikes down the tax.”

McKenna: “It’s really unfortunate that the State has decided to go ahead and collect a tax that the Superior Court has already invalidated. Not terribly respectful of that court or of taxpayers.”

I’d like to thank both attorneys for their time answering my questions and for their excellent work defending the longstanding precedent that Washingtonians own their income.

Additional Information
Capital gains income tax case: Three possible rulings
State Supreme Court hears oral arguments in income tax case
Background resources for capital gains income tax court hearing
Capital gains income tax webinar with Rob McKenna