Judge hears oral arguments in capital gains income tax case

OLYMPIA–Douglas County Superior Court heard oral arguments in the capital gains income tax case last Friday (2/4). The judge didn’t ask any questions until the very end of the hearing. Then he asked if the entire tax would be invalid if he found a constitutional problem or if a part of it could survive. He also asked if he needed to rule on all the constitutional challenges or if he agreed that it was unconstitutional under any of the challenges, he could stop his analysis on that. He indicated he planned to have a written ruling announcing his decision in two to three weeks.

At issue is whether a capital gains tax is an “excise tax” as claimed by the state, or instead an income tax as described by the IRS and every other tax department in the country. Under nearly 100 years of case law, income is property in Washington (meaning you own it) and a graduated/non-uniform tax on income is unconstitutional.

Before the new capital gains income tax was adopted, Washington’s Department of Revenue (DOR) expressed these concerns to lawmakers in prior years:

• “The federal capital gains tax is characterized as an income tax. One potential challenge to a capital gains tax proposal is that opponents may characterize the Washington capital gains tax as an income tax and argue that it is not allowed under the Washington constitution”;

• “susceptible to constitutional challenge as an income tax prohibited by the Washington state constitution”

• “potential confusion stemming from Washington’s proposed ‘excise’ tax on capital gains when the IRS characterizes the federal capital gains tax as an income tax.”

As noted by WA’s DOR, here is what the IRS says about a capital gains tax:

“You ask whether tax on capital gains is considered an excise tax or an income tax? It is an income tax. More specifically, capital gains are treated as income under the tax code and taxed as such.”

49 state revenue departments across the country agree with the IRS that a capital gains tax is an income tax.

Perhaps this is why WA’s Attorney General is asking the court to remove from the record any consideration of these details from the IRS, other states, and even public records from WA’s DOR.

After the capital gains income tax was adopted last year, WA’s DOR said in a memo:

“Another issue with the charitable deduction is that, because it is a common feature of income taxes, it may increase the chance that the courts will determine that the Washington capital gains tax is an income tax . . . The charitable deduction is not the only provision in the bill that opponents of the capital gains tax can point to in support of their argument that the capital gains tax is an income tax.”

Arguing for the plaintiffs last Friday was former Attorney General Rob McKenna. McKenna told the judge:

“We’re here today because the Legislature, frustrated that Washington voters refuse to approve a state income tax, has come up with another one of its periodic ‘excise tax’ work-arounds.

As Plaintiffs explain in their briefs, these ‘excise’ characterizations of taxes on income have been tried and rejected before, and so must this one.

This time, relying entirely on the IRS tax returns that Washington residents file, the Legislature has levied a tax on the same long-term capital gains that are indisputably characterized as ‘income’ under federal law, as ESSB 5096 -- the ‘Statute’ -- recognizes and calls out.

Although indistinguishable in every way from the federal income tax on which it is modeled, the Legislature has labeled the new capital gains tax an excise tax . . .

In the end, the Legislature claims that a tax derived wholly from the federal income tax, and based on income declared in federal tax returns, is not a tax on income. Its effort fails.”

As McKenna noted, this is not the first time the legislature has attempted to pass an income tax by calling it an “excise tax.” Those prior efforts were rejected by the court. My favorite state Supreme Court ruling on this point was in 1960. The justices said then in a short unanimous one-page order:

“The argument is again pressed upon us that these cases were wrongly decided. The court is unwilling, however, to recede from the position announced in its repeated decisions. Among other things, the attorney general urges that the result should now be different because the state is confronted with a financial crisis. If so, the constitution may be amended by vote of the people. Such a constitutional amendment was rejected by popular vote in 1934.”

In fact, the voters have rejected six proposed constitutional amendments to allow a graduated income tax. In total, the people have turned down 10 straight ballot measures seeking to impose an income tax.

Also providing oral arguments on Friday was the attorney for the national tax expert’s amicus brief that WPC joined. Joe Bishop-Henchman, VP Tax Policy/Litigation at National Taxpayers Union, told the court:

“You need more than magic words to turn a tax that acts like an income tax and talks like an income tax into something that’s not an income tax.”

Indeed.

A capital gains tax is either an income tax as unequivocally stated by every tax expert in the country, or WA lawmakers have discovered a magical spell to change the meaning of what an income tax is to fit within the constitutional restrictions that voters have repeatedly refused to change.

We’ll know which path the judge decides to take in a few weeks.

-Mercier is Director of the Center for Government Reform, Washington Policy Center.