ARTICLE | by RSM US LLP

Executive summary: Washington Supreme Court curtails application of B&O tax investment income deduction

On Oct. 24, 2024, in Antio, LLC v. Dept. of Revenue, the Washington Supreme Court affirmed a lower court holding that a business and occupation (B&O) tax investment deduction is limited to “incidental investments of surplus funds” and not available to investment income from primary business activities.

As a result, taxpayers across a wide range of businesses with Washington-sourced investment income, including family trusts and offices, private equity, and investment firms, could see a significant increase in their overall B&O tax liability due to this narrowed deduction. Prior to the ruling, businesses that were not a banking, lending, or security business (all specifically precluded by statute) commonly deducted any investment income.

Washington B&O tax investment income deduction no longer available to most businesses

The Washington Supreme Court held in Antio that the investment income deduction to the state’s B&O tax is limited to businesses with investment income comprising less than 5% of their annual gross receipts. This decision represents a significant change; for 20 years the Washington Department of Revenue interpreted the statute as allowing the deduction for taxpayers that were not a banking, lending or security business.

Background

Washington’s B&O tax is imposed on most forms of gross income unless an enumerated deduction or exemption applies. Dating back to 1935, Washington has permitted some form of an investment income deduction with respect to the B&O tax. Historically, amounts derived from investment income were deductible for all taxpayers except banking, lending, security, and ‘other financial businesses’ (collectively, the ‘investment income deduction’).

In 2000, the Washington Supreme Court expanded the definition of ‘other financial businesses.’ See Simpson Inv. Co. v. Dep’t of Revenue, 141 Wn.2d 139, 162, 3 P.3d 741 (2000). Following lingering uncertainty as to what constituted ‘other financial businesses,’ in 2002, the Washington Legislature enacted an amendment to remove the limitation on ‘other financial businesses’ entirely. The Washington Legislature indicated this change was made “to provide a positive environment for capital investment in [Washington].”

From 2002 to 2019, the department appeared to acquiesce to a broadened application of the investment income deduction. The department’s own website, following the 2002 legislative amendment, stated that most mutual funds, private investment funds, family trusts, and other collective investment vehicles were allowed the B&O tax deduction for amounts derived from investments.

The challenge

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 department denied the refund and the taxpayers appealed. The trial court and appellate court decided in favor of the department.

On Oct. 24, 2024, the Washington Supreme Court held, in a 7-2 decision, that the intent of the 2002 legislative changes to the investment income deduction was limited to the narrowing of which businesses were explicitly not eligible for the deduction. In other words, the 2002 legislative changes permit ‘other financial businesses’ to claim the investment income deduction, but to do so, these businesses must still comport with all other parts of the investment income deduction statute.

Specifically, the Court relied on a 1986 decision, O’Leary v. Department of Revenue, 717 P.2d 276 (1986), in which the Court defined ‘investments’ for purposes of the investment income deduction. In O’Leary, the definition of ‘investments’ under the statute was held to be the “incidental investment of surplus funds.” The O’Leary court further interpreted ‘incidental’ to mean less than 5% of the annual gross receipts of a business.

As the taxpayers in Antio earned 100% of their income from investments, the Court found the taxpayers’ investment activities were greater than an “incidental investment of surplus funds” and disallowed the investment income deduction.

By way of the Antio decision, any taxpayers that intend to claim the investment income deduction need to ensure their investment income is an “incidental investment of surplus funds,” or less than 5% of the business’ annual gross receipts. Although the taxpayers in Antio recently filed a motion for reconsideration, it is likely the Court’s decision will stand.

Importantly, the department looks to be taking the position that the investment income deduction was always limited to “an incidental investment of surplus funds,” and not merely effective as of the date of the Court’s decision. By virtue of this interpretation, and by disregarding guidance previously provided on its own website, the department is opening the door to future audits and imposing B&O tax, along with penalties and interest, upon certain taxpayers that claimed the investment income deduction in prior periods.

The department has yet to promulgate regulations or other guidance regarding how investment income should be sourced. Additionally, as of the date of this article, the department has not indicated whether any type of safe harbor will be offered to taxpayers to incentivize compliance and mitigate penalties for prior periods.

It is not known whether the Washington Legislature intends to address this matter in a future legislative session.

Takeaways

Antio significantly impacts the B&O tax liability of many 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. With the Court’s affirmation of 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.

For affected taxpayers exceeding 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 exposure.

Taxpayers with questions about Antio or the Washington B&O tax should speak to their Washington state and local tax advisors.

Geffen Mesher’s State and Local Tax (SALT) team is available to assist you with questions related to these updated rules. Please contact our professionals for more information at SALT@GMCO.COM.

This article was written by David Brunori and originally appeared on 2024-12-12. Reprinted with permission from RSM US LLP.
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