Initiative 1098 and capital gains income: A follow-up

In response to my earlier post about capital gains income and Initiative 1098, Kriss Sjoblom at the Washington Research Council writes:

Capital gains income is not, in general, exempt from the I-1098 income tax. The only exception to this concerns the sale of a primary residence, where federal tax law excludes the first $250,000 in gain for an individual selling a primary residence ($500,000 for a couple) from AGI. Specifically, capital gains from the sale of a business are fully included in AGI and taxed just like ordinary income.

Actually, it turns out that under federal tax law, capital gains from selling certain small-business stock do qualify for a special exclusion rule:

Noncorporate investors may exclude up to 50 percent of gain they realize on the disposition of qualified small business stock issued after August 10, 1993 and held more than five years. The exclusion is 60 percent if the qualified small business stock is issued by a corporation in an empowerment zone. The exclusion is 75 percent for stock acquired after February 17, 2009 and before January 2011.

But that wasn’t part of my original point – or post, for that matter – about the tax implications of I-1098 when selling a business. My point was that even without a specific exclusion for capital gains income, Initiative 1098’s high income threshold could function to exclude capital gains anyway.

Two pieces of this discussion warrant further clarification:

First: under Initiative 1098, adjusted gross income (AGI), as defined by the IRS, is the basis for determining whether any state income tax is owed at all, and if so how much.

In other words, since the IRS includes capital gains income as part of AGI, so does I-1098. Since the IRS allows certain capital gains to be excluded from AGI – for selling a home or some kinds of business stock, for example – so does I-1098. Since business expenses for rental real estate, royalties, partnerships, S corporations, trusts, etc. count against AGI (via Schedule E), as do other expenses and losses (see lines 23 through 27 of Form 1040), they also do under I-1098.

Second: Initiative 1098’s built-in high income threshold means no state income tax is paid at all on the first $400,000 of household AGI ($200,000 individual) regardless of income source.

As I noted in an earlier post, that offers a more level playing field for Washington’s small businesses than our state’s existing tax structure does. Whether it is money from daily wages, winning the lottery, capital gains or taking a share of a corporation’s profits, the same rates and thresholds apply to all under I-1098.

Kriss’ post takes issue with my use of an example in which a business is sold, writing:

The example is concocted so that the tax due on the sale of the business is minimal. But this is the case because the value of the business is low, the business is owned by a married couple rather than a single individual and the business owners have no income other than the capital gain from the sale of the business. As result most of the gain from the sale is shielded by the exclusion of the first $400,000 of a couple’s income from the I-1098 tax.

It’s clear that if the value of the business were higher, or the seller had other income, then more tax would be paid. It is, after all, an income tax we’re talking about here. But of course, in that case the seller of the business would also be taking home far more from the sale.

For example, $1 million in net income would mean a $30,000 tax payment, netting $970,000 – an effective tax rate of just 3%. Bump it up a notch: $10 million in net income means $840,000 in state income tax. That sounds steep until you realize the seller comes away with a cool $9.16 million, for an 8.4% effective tax rate.

It matters not whether a married couple owns the business, but whether the income is reported on a joint or individual return. And IRS data clearly shows that 85% of high-income tax returns are filed jointly, so the example is quite fair in that regard.

A brief aside in closing: Kriss’ comment about capital gains being “taxed just like ordinary income” highlights an interesting aspect of state vs. federal income taxes. In most of the 43 states with an income tax, capital gains income is treated the same as other income. But the federal tax code offers a special, lower tax rate for capital gains income:

The advantage of capital gains, as opposed to ordinary income, is that the basic maximum tax rate on capital gains for property held for more than one year is currently 15 percent. In contrast, the top four ordinary income tax rates are all higher than this, with the top rate for 2005 through 2010 at 35 percent.

Whether that makes for good federal tax policy is a topic for another day. But for context, it’s worth noting that tax filers with lots of capital gains income already enjoy a lower federal tax rate than those whose income primarily comes from other sources, such as regular wages.

Looking for more information about Initiative 1098? Visit the Economic Opportunity Institute website.

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