Evaluating Washington’s Proposed Millionaires’ Tax

Washington lawmakers are holding their first hearing on long-anticipated legislation that would create a new 9.9 percent taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. on income over $1 million. It comes only two years after lawmakers approved an initiated statute prohibiting state or local income taxes, and presents a direct challenge to over 90 years of judicial precedent restricting the adoption of income taxes in the state. Voters have rejected income tax proposals 10 times, most recently in 2010.

Washington already taxes capital gains income above $278,000, at rates of 7 and 9.9 percent. The new tax would coexist with the capital gains income tax—albeit sometimes uncomfortably—rather than replacing it.

As we have noted previously, the proposed tax would yield a top rate of more than 18 percent in Seattle when combined with two Seattle wage taxes and a statewide uncapped payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue., making it the highest rate on wage income in the country. The proposed tax would fall largely on small business owners and on tech workers receiving Restricted Stock Units (RSUs) in compensation, and would be particularly detrimental to employees at startups that have yet to go public and whose RSUs could all vest at once.

Now that language has been introduced, further analysis is possible. Several items stand out.

1. The bill is stingier than most other income taxes.

The legislation contains an express marriage penaltyA marriage penalty is when a household’s overall tax bill increases due to a couple marrying and filing taxes jointly. A marriage penalty typically occurs when two individuals with similar incomes marry; this is true for both high- and low-income couples.. Although it is meant to apply to income above $1 million, which is achieved through a standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. Taxpayers who take the standard deduction cannot also itemize their deductions; it serves as an alternative., the deduction is the same for both single and joint filers. Furthermore, charitable deductions are capped at $50,000, which is highly unusual. Recent federal changes limit all itemized deductions, including the charitable deduction, to 35 percent of adjusted gross incomeFor individuals, gross income is the total of all income received from any source before taxes or deductions. It includes wages, salaries, tips, interest, dividends, capital gains, rental income, alimony, pensions, and other forms of income.
For businesses, gross income (or gross profit) is the sum of total receipts or sales minus the cost of goods sold (COGS)—the direct costs of producing goods (AGI), but other states and the federal government do not impose dollar-denominated caps. Someone could give away tens of millions and still only reduce taxable income by $50,000. The legislation also taxes interest on state and local bonds, except those issued in Washington.

2. The bill eliminates the benefit of the lower rate on capital gains for some filers.

The existing tax on high earners’ capital gains income has a $278,000 (inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spendin-indexed) standard deduction, with a rate of 7 percent for taxable gains income up to $1 million and 9.9 percent above $1 million. The new legislation does not eliminate this tax. Instead, it interacts with it by taking federal AGI, subtracting all capital gains income, adding back Washington capital gains income taxed under the capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. , and then providing a credit against the new income tax for taxes paid under the capital gains tax.

The upshot of this somewhat convoluted structure is that if filers have enough earned income, then both their earned and unearned income above $1 million in aggregate would be taxed at 9.9 percent, while the credit would only offset liability under a tax that exempts the first $278,000 in capital gains income and taxes additional income at a 7 percent rate. Functionally, with enough earned income, the new tax would “fill in the gaps” and gross up the tax on all capital gains income to 9.9 percent. It would also override the charitable deduction within the current capital gains tax structure.

3. The bill allows entity-level taxes, but with drafting errors.

Most state income taxes now allow owners of pass-through businesses (S corporations, partnerships, LLCs, etc.) to elect to pay taxes at the entity level, avoiding the federal income tax’s state and local tax (SALT) cap deduction. The owners of the business then receive a corresponding credit against their own individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source liability. The proposed Washington income tax includes such a pass-through entity (PTE) tax.

The legislation appears to address the primary issue with an entity-level tax in Washington: the $1 million standard deduction. If the PTE tax applied to all the entity’s income, this would be gross over-taxation, and owners would receive nonrefundable credits they couldn’t fully use. The legislation seeks to address this by establishing that the owners’ deductions and adjustments are to be included in the calculation of PTE tax liability.

However, the bill appears to contain two drafting errors. Less significantly, it defines pass-through businesses as “disregarded entities,” but that is a term that only applies to LLCs and sole proprietorships. S corporations and partnerships are not disregarded entities. The bill enumerates both of these types of pass-through businesses, so it is likely that the Department of Revenue would understand the reference to “disregarded entities” to be in error and grant eligibility to S corporations and partnerships, but a technical fix would still help.

More importantly, the credit is written to apply against “the tax imposed under this section” (§ 502) rather than “this chapter.” This means the credit generated by paying entity-level taxes would be applied against the entity-level tax itself, instead of against the owners’ income tax liability—which is circular and counterproductive. While this is clearly just a drafting error, it is a consequential one that must be addressed for the PTE tax regime to function.

4. The bill permits reciprocity agreements—maybe.

Some states enter into reciprocity agreements with each other, under which individuals who live in one state but work in another are only taxed in their domiciliary state, rather than paying taxes to both and receiving a tax credit for taxes paid to other states. This is a welcome simplifying measure, and to the drafters’ credit, they include authorization for the Washington Department of Revenue to enter into reciprocity agreements with other states that already authorize them.

Technically, however, the language is conditional. A strict reading suggests that the Department can only enter into such an agreement with another state if that state does not provide credits for taxes paid to other states. But all states offer those. The reciprocity agreements, when entered into, provide an override system for taxpayers in the reciprocating states, but there is always baseline availability of credits in law. If this is interpreted as conditional on the other state not offering credits for taxes paid to other states, then the Department would never be allowed to enter into these agreements. A common-sense interpretation might well prevail here, but clarity would help.

5. The bill leaves conformity up to the regulators.

Some states have static (fixed-date) conformity with the Internal Revenue Code (IRC), requiring lawmakers to update the conformity date regularly to ensure that the state is aligned with federal law changes. Other states have rolling conformity, where they automatically align with the current version of the IRC. Conformity brings in relevant judicial decisions, regulations, and the like. All of this is important for many reasons, including the ability to piggyback on IRS audits.

The Washington bill is a little different. It sets a fixed date for conformity—January 1, 2026—but then allows the Washington Department of Revenue, by regulation, to revise that date. The bill would be improved by simply implementing rolling conformity.

Conclusion

Fundamentally, whatever its finer points, this is a high-rate income tax in a state that already imposes aggressive taxes on businesses. In the absence of an income tax, lawmakers have long imposed heavy taxes on business activity, and unfortunately, this bill makes no significant changes to those existing taxes even as it imposes a high-rate income tax on small business owners and other high earners.

There is a growing divergence between low- and high-tax states. With this legislation, Washington would double down on being a high-tax state, particularly for businesses and for some of its most mobile taxpayers.