Legal battle over capital gains tax kicks off in Douglas County court

The legal battle over Washington’s new capital gains tax is scheduled to be heard in a Douglas County courtroom Friday morning.

Court battle over capital gains tax could rewrite Washington’s tax code

At the heart of the issue is whether the 7% tax on capital gains above $250,000 from the sale of things like stocks and bonds is an excise tax or an income tax. If it’s an income tax, as the IRS and countless other experts have said, then it must be uniform, which the capital gains is not, based on a decades-old state Supreme Court decision that lawmakers have tried to circumvent for years in order to get to an income tax without success.

Many see this capital gains tax fight as yet another effort to try to get the state Supreme Court to undo years of precedent and clear that path to an income tax. For now though, the battle centers on that question of whether it is an income or an excise tax.

Despite a letter from the IRS stating clearly that the capital gains tax is in fact an income tax, and thereby considered property under that 1930s court decision and required to be uniform, capital gains tax advocate and Democratic State Rep. Noel Frame contends this is an excise tax.

“A capital gains tax in Washington State law is considered an excise tax,” Frame told KIRO Newsradio’s Dori Monson in 2021, as she laid out what she believed to be a good comparison.

“We talk about different types of property in Washington state,” she described. “When you sell your house, which is real property, you pay a real estate excise tax. When you sell a capital asset, like a financial intangible asset, like a stock or a bond, right now you pay 0% on that sale.”

“This capital gains tax, that is the transaction on that sale that is very comparable to the real estate excise tax that middle class people already pay on their one asset of wealth their home,” she continued. “So it’s just parity in the tax code, and we really do believe it is an excise tax.”

Frame also said at the time that she did not believe an IRS definition of the capital tax as an income tax was relevant.

“The IRS does not control and dictate what state tax law is,” she clarified. “And in state tax law, [a capital gains tax] is an excise tax.”

Jason Mercier with the Washington Policy Center disagrees.

“For the past 100 years, income is still property under multiple Supreme Court rulings, and everybody across the world, from the IRS to every other state, to other countries will tell you the same thing — capital gains are income, which makes them property,” said Mercier, adding that it appears the state attorney general — who will argue for the state in Friday’s court hearing — appears to know this poses a problem for his case.

“I think the attorney general probably realizes that that looks bad for his case, because he actually filed a motion with the judge to strike it from the court record,” Mercier explained. “He’s asking the court to ignore public records from the IRS, from revenue departments across the country, even public records from Washington’s Department of Revenue, which identified this as a tax on income. I think that’s an indication of what the attorney general knows he’s up against when everybody else in the world says the same thing: This is an income tax.”

The AG claims those records are hearsay.

That motion is rolled into Friday’s summary judgment hearing, so any arguments could shed more light on which way the Douglas County judge is leaning.

The legal fight over capital gains is also nothing new.

“There has been an ongoing effort to bring Washington an income tax, and repeatedly the court has said that if you want to do a graduated income tax, you have to amend the Constitution,” Mercier said. “Voters have rejected six constitutional amendments. So you see advocates of income taxes, realizing they can’t get voter support, try to do these end runs from the courts, when they call it an excise tax. And multiple times, the Supreme Court said, ‘I don’t care, we don’t care what you call it, it’s an income tax, it’s unconstitutional.'”

“My favorite ruling from them was in 1960, it was just a one-page order,” he added. “It said ‘stop asking us, we’re not changing our minds, income is property, and if you want a graduated income tax, you’ve got to amend the Constitution.'”

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Many observers believe this case will ultimately be decided by the state Supreme Court as well, but it is not a given that the state high court will take the case, depending on how it shakes out in lower courts.

“No matter what happens in this first round, I can tell you with 110% certainty there will be appeals by the losing party,” Mercier predicted. “The only real drama is does that go directly to the state Supreme Court? Or does it go first to the Court of Appeals? How that unfolds could determine how high up this goes.”

“Because, if you remember with the Seattle income tax case, which was the first attempt to try to use the courts to open the door to an income tax, the Supreme Court refused to hear that case, because both lower courts agreed that it was unconstitutional, which matches up with over 100 years of case law,” he added. “So if we see a situation where the trial court rules in favor of the plaintiffs and the appeals court agrees it is unconstitutional, there’s a possibility the Supreme Court may decide not to take the case.”

Mercier expects the legal battle to take years. The law that created this version of the capital gains tax took effect in July, but the tax itself is not set to be collected until 2023.

Even before the tax is collected, a pair of Democrats who originally sponsored the bill creating the capital gains tax — Senators Joe Ngyuen and June Robinson — have dropped a new bill seeking to double the tax rate to 14%. So far, no hearing has been set for that bill.

You can watch the oral arguments in the capital gains tax case at 10 a.m. Friday on TVW here.

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