McKenna states case against Washington’s capital gains income tax

Former Washington State Attorney General Rob McKenna detailed the legal case against the state’s new capital gains income tax during a recent online seminar put on by the free market Washington Policy Center think tank.

McKenna, one of the lead attorneys in the case against the tax, previewed some of the legal issues the state Supreme Court will consider when oral arguments start on Jan. 26.

In 2021, the Legislature passed and Gov. Jay Inslee signed into law a capital gains income tax aimed at the state’s wealthiest residents. The measure adds a 7 percent tax on capital gains above $250,000 a year, such as profits from stocks or business sales.

On March 1, 2022, Douglas County Superior Court Judge Brian Huber ruled the tax was “properly characterized as an income tax … rather than as an excise tax as argued by the State” and struck it down. The state constitution’s uniformity clause does not allow income to be taxed at different rates.

Washington Attorney General Bob Ferguson asked the state Supreme Court to take up the case on appeal, with the high court agreeing to do so.

The Supreme Court has since given the okay for the state Department of Revenue to administer and collect the tax in the meantime.

“The incidents of the tax in this case — as in prior cases — is the generation of a net gain or a net income, which is then taxable,” McKenna explained Wednesday in pushing back against the notion the capital gains tax is an excise tax, or a tax imposed on the sale of specific goods or services. “That tells us that the tax is not really concerned about exercising a privilege like transferring real estate or handing down an estate. All it’s really concerned about is whether or not you’ve generated a net income from the sale or transfer of long-term capital assets.”

The prior cases McKenna referred to are Supreme Court decisions he said backed up his claim — and the basis for Huber’s ruling — that income is property and property has to be taxed uniformly:

• In the 1933 case of Culliton v. Chase, the justices invalidated a voter-approved progressive income tax meant to pay for education.

• In the 1936 case of Jensen v. Henneford, the justices ruled that a state tax “on the privilege of receiving income” violated state uniformity requirements.

• In the 1951 case of Power, Inc. v. Huntley, the court said, “The character of a tax is determined by its incidents, not by its name.”

Beyond the state-level basis for Huber’s ruling that the tax is unconstitutional, McKenna claimed the tax also runs afoul of the U.S. Constitution.

“Excise taxes are levied and collected by a state in exchange for granting a particular privilege,” he said.

Because the tax would apply to all long-term capital gains regardless of wherever they are generated, McKenna said that would be an attempt to collect a tax on activities outside Washington over which the state has no jurisdiction.

“Therefore, it violates the Due Process clause of the federal Constitution, which says that states might only tax that which they have jurisdiction over,” McKenna said. “And it violates the Commerce Clause of the Constitution, which states you cannot reach activity outside of the state with a tax over which you have no control.”

Regarding the possibility of a federal lawsuit should Washington’s highest court affirm the state’s position, McKenna said it’s not easy to challenge state taxes in federal court.

“If the Supreme Court abandons its prior precedents and decides that this tax is an excise tax simply because the Legislature says it is — again a position this court has never taken before — the best option is probably to repeal it,” McKenna advised. “It is after all just a statute and it can be repealed by initiative, as we’ve seen happen before.”