United States: Washington Initiative 1098 - Tax Proposals Appearing on November Ballot

Last Updated: September 14 2010
Article by Steven Schindler, Bruce Flynn, Tom Gores and Bob L. Mahon

A tax proposal, Initiative 1098, has been certified by the Washington State Elections Division and will appear on the November ballot. I-1098 would impose a state excise tax on personal adjusted gross incomes above $200,000 ($400,000 for couples), reduce the state portion of property taxes by 20% and reduce or eliminate the business and occupations (B&O) tax paid by small businesses. The main features of I-1098, with an emphasis on the income tax provisions, are summarized below.

Persons Subject To Tax

The proposed tax (an excise tax on the receipt of adjusted gross income) applies only to individuals—it does not apply to business entities or to estates or trusts. However, distributions to individuals from estates or trusts would be subject to the tax to the extent they are included in the beneficiary's federal income tax.

Income Subject to Tax

Virtually all income subject to federal tax would also be subject to the proposed Washington tax. I-1098 generally applies the federal income tax code for purposes of determining the tax. The exceptions are that residents of other states earning income from Washington sources will have their federal taxable income apportioned between their state of residence and Washington and that certain income from U.S. obligations like bonds for which federal law prohibits state income tax assessments will not be subject to the Washington tax.

Notably, unlike the income tax laws in states such as California and Oregon, I-1098 would not subject state and local bond income that is tax-exempt under federal law to the Washington tax, whether the state or local authorities issuing the bonds are within or outside the state of Washington.

Because the tax is determined on the basis of federal adjusted gross income, deductions and credits applicable under federal tax law would not reduce the amount of state tax due. Deductions for medical expenses and charitable contributions, and credits for dependents, are not factors in determining the Washington tax due.

Tax Brackets and Rates

For married spouses and registered domestic partners, the I-1098 tax rates are 5% on the amount of taxable income between $400,000 and $1,000,000 and 9% on income in excess of $1,000,000. For individuals, the same rates apply at half the bracket thresholds: 5% on income between $200,000 and $500,000 and 9% on income in excess of $500,000. The tax is a marginal tax, meaning couples with adjusted gross incomes of $410,000 would only pay a tax of 5% of $10,000 in excess of $400,000, or $500.

A credit is available for any income tax imposed by another jurisdiction on income generated in that jurisdiction up to the Washington tax calculated on the same income.

Residency

Washington residents would be subject to tax on all of their federal adjusted gross income regardless of the source of such income, subject to the modifications and credit described above.

A "resident" is defined in I-1098 as an individual who
(1) has resided in the state for the entire year,
(2) is domiciled in the state, unless the individual maintains no permanent place of abode in the state, does not maintain a permanent place of abode elsewhere, and spends less than 31 days in the state, or
(3) is not domiciled in the state but maintains a permanent place of abode in the state and spends more than 183 days of the tax year in the state, unless the person is in the state only for temporary or transitory purposes.

An individual domiciled in another state may spend as many as 182 days of the year in Washington at a permanently maintained home without being characterized as a resident under I-1098. "Domicile" and "residency" tend to be very fact intensive legal determinations.

Nonresidents

Nonresidents are taxed only on income derived from sources within Washington. Income derived from sources within Washington include "the net amount of items of income, gain, loss, and deduction derived from or connected with sources within Washington attributable to the ownership or disposition of any interest in real or tangible personal property in this state, and a business, trade, profession, or occupation carried on within this state." Income from intangible personal property (investment income) constitutes income derived from sources within Washington only to the extent that the property is employed in a business, trade, profession, or occupation carried on within this state. This includes a nonresident shareholder's allocation of income from an electing S corporation derived from sources within Washington.

The same income tax rates and brackets apply to nonresidents' Washington income.

Dual Residents

The Initiative contemplates that its residency rules may result in a taxpayer being considered residents in two states for income tax purposes. In such a circumstance, the tax applicable to income on which another jurisdiction seeks to impose tax is prorated, but only if the other jurisdiction permits a reciprocal proration of the tax.

Examples

First, assume a Washington married couple, filing jointly in 2009, reported $500,000 in adjusted gross income, with $50,000 in itemized deductions, and was not subject to the alternative minimum tax. Total federal income tax due would have been about $127,000. If the income tax provisions in I-1098 had been applicable that year, the couple would have owed additional Washington tax of $5,000. If federal tax law permits a taxpayer to choose whether to deduct state sales tax or state income tax in calculating federal income tax liability (as it did in 2009), then the additional Washington income tax may not provide an additional deduction, as the state sales tax may provide a greater deduction than the income tax at this income level.

Second, assume a Washington married couple, filing jointly in 2009, reported $2,000,000 in adjusted gross income, with $100,000 in itemized deductions, and was not subject to the alternative minimum tax. Total federal income tax due would have been about $640,000. If the Washington tax under I-1098 would have applied, the Washington tax due would have been $120,000. Further, because this amount would have exceeded the total state sales tax paid, the I-1098 tax would have been deductible for federal income tax purposes. If, for example, the deductible state taxes had totaled $25,000 of the $100,000 in itemized deductions, the increased deduction would have lowered the federal income tax down to about $607,000. The combined federal and Washington income tax would have been $727,000, or an increase in total tax liability of $87,000 resulting from the application of I-1098.

Finally, assume a Washington married couple, retired, filing jointly in 2009, received $400,000 in ordinary income and an additional $300,000 in tax-exempt municipal bond income. The couple's adjusted gross income was $400,000, they reported $50,000 in itemized deductions, and they were not subject to the alternative minimum tax. Their federal tax liability would have been about $93,000. Even if I-1098 had applied, the couple would have owed no additional tax because tax-exempt municipal bond income is not subject to tax under I-1098.

Effective Date

If I-1098 passes in November, it would not take effect immediately. The tax would most likely be applicable to income recognized starting in 2012.

Fiscal Impact

The State Office of Financial Management has issued a report projecting revenue forecasts if I-1098 passes. The report projects $2.213 billion in revenues from the income tax in the first year, 2012, and net revenues from all of the provisions of I-1098 for the years 2012-2016 to total $11.16 billion.

Current Polling

The most recent poll, conducted August 26 to 29 by Survey USA, with 650 respondents, found 41% in favor of I-1098, 33% opposed, and 26% undecided. Survey USA indicates that opposition to ballot measures typically builds as an election approaches.

An earlier poll, conducted by Public Policy Polling from July 27 to August 1 among 1,204 respondents, found 41% in favor, 41% opposed, and 18% undecided.

Constitutionality

Some commentators have noted that the Washington Supreme Court, in a 5-4 decision, struck down an income tax law in 1933 and believe that the constitutionality of I-1098 is in doubt. A former Justice of the Supreme Court has argued that those precedents are indeed binding and that I-1098 is clearly unconstitutional. Another tax law expert has argued, to the contrary, that today's Supreme Court would hold, as forty-eight other states have done, that the rationale for those decisions was flawed and that I-1098 would pass constitutional muster. In either case, if I-1098 is passed, court challenges are likely to ensue.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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