Rep. Noel Frame, lead sponsor of the 2021 capital gains tax. (Noel Frame Photo)

With time running out on the legislative session, Washington state lawmakers approved a $59 billion state budget including a tax on capital gains that has divided the region’s tech community.

The Sunday vote on the capital gains bill, mostly along party lines, primarily targets stock and business ownership sales with a 7% tax for the first time in state history.

Rep. Noel Frame, a Seattle Democrat who was a key advocate of the measure, said she was thrilled the bill finally moved through the legislature.

“I’ve been working on this for a decade,” she said Sunday afternoon shortly after the bill’s narrow 25-24 vote in the state Senate. “This is a really important step toward progressive tax reform.”

It’s also going to be a target by groups who see a capital gains tax as an income tax by another name. Income taxes are unconstitutional in Washington state. “It’s unquestionably an income tax,” said Jason Mercier, an attorney with the conservative Washington Policy Center. “The IRS considers capital gains an income tax. So do we.

“This will be challenged in court,” he added.

Frame said she expects nothing less than a full legal attack by the measure’s opponents. But she remains confident the tax will stay on the books because she sees it as an excise tax similar to a sales tax and not an income tax. “I would be deeply surprised if they don’t bring a lawsuit,” she said.

Proponents see the tax as more comparable to the state’s existing Business and Occupation Tax which is assessed similarly to an excise tax but based on a business’ income. And that business income essentially is its owners’ income. “Based on (precedent), we feel there is good case law to interpret this as an excise tax,” Frame said.

Broadly, statehouse Democrats see the tax as a way to modify the state’s regressive tax code that relies heavily on fees such as sales taxes which disproportionately affect low-income residents. Republicans view the tax as illegal and unnecessary based on the state’s unexpected economic recovery.

The tax is estimated to raise about $550 million annually starting in fiscal year 2023. The majority of the funds would go toward early education and childcare.

And as for those federal capital gains taxes you might already be paying? Those, too, might be going up under a new Biden administration proposal.

The $59 billion budget is actually higher than the prior two-year budget because it is buoyed by a stronger-than-expected economic recovery. Moreover, it’s far from all of the money the state will be spending next year. Lawmakers are counting on an additional $10 billion in federal pandemic relief funding for families, businesses, and schools.

In all, the budget earmarks money for a tax exemption for low-income families, child care programs, and forest and wildfire management, among other programs. The additional federal money will include more than half a billion dollars in rental assistance and another $500 million in funds to help businesses offset soaring unemployment insurance costs related to the massive layoffs of one year ago.

But it is the capital gains tax that drew the consistent attention of the tech, business, and legal communities during the legislative session.

Under the tax, the first $250,000 of capital gains would be exempt from the tax, as would specific asset sales. For example, stock sales higher than $250,000 would be taxed at 7%. Real estate would not be.

From the legislative staff analysis: “Excluded (from the proposed capital gains tax): all real estate land and structures; assets held in a retirement account; assets transferred as part of a condemnation proceeding; livestock related to farming or ranching; certain types of property used in a trade or business such as machinery and equipment that have been immediately expensed; timber and timberlands; and goodwill received from the sale of a franchised auto.”

A letter published by the Washington Technology Industry Association, which represents more than 1,000 tech startups and larger companies, warned the tax will “remove a meaningful attraction and retention mechanism” for startups and “harm our competitiveness.”

Venture capitalist Nick Hanauer was dismissive of the WTIA’s claim.

“The WTIA letter’s central claim is that adopting a tax on extraordinary capital gains will make Washington inhospitable to startups and lead them to locate elsewhere, but this is demonstrably false,” Hanauer’s Civic Ventures wrote in response. “Virtually every state that is a leader in high-tech startups — like California, Massachusetts, New York, and Virginia — also has a state tax on capital gains.”

The bill also briefly became bogged down over language that prevents opponents of the tax to file a state voter referendum to challenge the measure. That language remained in the final bill, so any challenge of the tax will have come in the form of a lawsuit or the state initiative process.

Gov. Jay Inslee is expected to sign the legislative package in the coming three weeks. Only after he signs the capital gains tax can it be challenged in court.  “Once that happens, someone will file a lawsuit,” Mercier said.