Executive summary: Washington Supreme Court to review the B&O tax investment income deduction
On Aug. 8, 2023, the Washington Supreme Court granted taxpayers’ petition for review in Antio, LLC v. Dept. of Revenue, a case that may have broad impacts on family trusts and offices, private equity and investment firms. In April, the Washington Court of Appeals disallowed a business and occupation (B&O) tax deduction for investment income commonly utilized by taxpayers, finding that the deduction is only available when investments are “incidental to the main purpose of the taxpayer's business.” The appellate court narrowed the availability of the investment income deduction to only businesses with investment income comprising less than 5% of their annual gross receipts.
If the application of the investment income deduction is affirmed on appeal, taxpayers across a wide-range of investment businesses could see a significant increase in their overall B&O tax liability. Read more about the deduction and what affected taxpayers should do now during the pendency of the appeal below.
Fate of the investment income deduction to be decided
Washington’s B&O tax is broadly imposed on most forms of gross income in Washington unless an enumerated deduction or exemption applies. Historically, amounts derived from investment income were deductible for all taxpayers except banking, lending, security, and ‘other financial businesses’ (collectively, the ‘investment income deduction’). See Wash. Rev. Code section 82.04.4281. Following uncertainty as to what constituted ‘other financial businesses,’ in 2002, the legislature enacted an amendment removing the limitation on ‘other financial businesses,’ allowing these taxpayers to claim the investment income deduction.
The taxpayers in Antio are a group of 16 investment funds earning 100% of their income from investments, performing no services, and not otherwise classified as banking, lending, or security businesses. The taxpayers requested a refund for B&O tax paid on investment income under the investment income deduction for a three-year period. The Washington Department of Revenue denied the refund and the taxpayers appealed.
The appellate court found that for purposes of the investment income deduction, the meaning of the term ‘investments’ was controlled by a 1986 Washington Supreme Court case decided when the investment income deduction was unavailable to ‘other financial businesses.’ In this 1986 case, O’Leary v. Dept. of Revenue, the Washington Supreme Court held [w]hether an investment is 'incidental' to the main purpose of a business is an appropriate means of distinguishing those investments whose income should be exempted from the B&O tax.’ Accordingly, the O’Leary court determined that an investment must be incidental to the main purpose of the taxpayer’s business to qualify for the investment income deduction. The O’Leary court further interpreted incidental to mean less than 5% of the annual gross receipts of a business, based on the statutory language of the investment income deduction. Until Antio, this 5% threshold was widely considered to have been superseded by the 2002 amendment allowing ‘other financial businesses’ to claim the investment income deduction.
Antio could significantly impact the B&O tax liability of family trusts and offices, private equity funds, venture capital funds, mutual funds, and other businesses that earn a substantial amount of Washington-sourced income from investments. If the state high court affirms the department’s position, Washington-sourced investment income earned by taxpayers not considered ‘incidental’ will be subject to B&O tax at a rate of 1.5% or 1.75%, instead of eligible for deduction.
Affected taxpayers should monitor the litigation closely. If a taxpayer exceeds the 5% gross receipts threshold, an investment income sourcing review should be considered to optimize or minimize potential B&O tax liability. Additionally, routinely reviewing Washington-sourced income for proper receipts classification, deduction and exemption opportunities and sourcing optimization may help mitigate B&O tax exposure.
Taxpayers with questions about Antio or the Washington B&O tax should speak to their Washington state and local tax advisers.