Washington’s Capital‑Gains Tax and QSBS: A Founder’s Guide

Introduction

Washington State introduced a capital‑gains tax in 2021, triggering immediate interest (and litigation) among founders, investors and tax professionals. The tax is unusual because Washington has no personal income tax; it’s a standalone excise tax on long‑term capital gains above a certain threshold. At the same time, federal law under § 1202 of the Internal Revenue Code provides a powerful exclusion for gains from Qualified Small Business Stock (QSBS), often allowing founders and early investors to shield up to $10 million (or ten times basis) from federal capital‑gains tax. This guide explains how Washington’s tax works, how QSBS fits into the picture, recent legislative developments, and practical planning tips.

1. Overview of Washington’s Capital‑Gains Tax

Washington’s tax applies to long‑term capital gains realized by individuals. Key features include:

• Threshold and rates: Currently, the first $250 000 of annual long‑term capital gains is exempt. Gains above that are taxed at 7 %, with proposals to add a 9.9 % bracket for gains above $1 million.
• Scope of tax: The tax targets gains from the sale or exchange of assets such as stocks, bonds, business interests and tangible property. It does not apply to real‑estate gains, retirement‑account distributions, or certain agricultural property.
• Who pays: The tax is imposed on individuals. Entities such as corporations and LLCs are not subject to it directly; however, pass‑through gains flow to owners and count toward their threshold.
• Current status: The tax survived court challenges and is now in effect, though the legislature continues to debate modifications. It is administered by the Washington Department of Revenue.

2. Section 1202 and QSBS Essentials

Section 1202 of the Internal Revenue Code allows holders of Qualified Small Business Stock to exclude up to 100 % of the gain from the sale of that stock if they meet several requirements:

• Qualified corporation: The issuing company must be a domestic C‑corporation with aggregate gross assets ≤ $50 million at the time of and immediately after issuance.
• Original issuance: The stock must be acquired at original issuance (not secondary market) in exchange for money, property (other than stock), or services.
• Holding period: The taxpayer must hold the stock for more than five years.
• Active business requirement: The corporation must use at least 80 % of its assets in the active conduct of a qualified trade or business during most of the holding period.
• Exclusion limits: For stock issued after Sept 27 2010, the exclusion is 100 % of the greater of $10 million or ten times basis; earlier issuance dates have 50 % or 75 % exclusions.
  For founders and early investors, QSBS can completely eliminate federal capital‑gains tax on a significant portion of their exit proceeds.

3. Does Washington Tax QSBS Gains?

The short answer, at least for now, is generally no—if you qualify for the federal § 1202 exclusion, Washington doesn’t separately tax those gains. Several of our blog posts have explained that Washington “piggybacks” on the federal definition of capital gain and does not tax gains the federal government has already excluded (Does Washington’s Capital Gains Tax Apply to QSBS Gains?). One post even illustrates that a Seattle founder who sells stock for a $20 million gain and excludes $15 million under § 1202 would owe state tax only on the remaining $5 million (The OBBBA expands QSBS exclusions - Business tax).
However, not all commentary is consistent. A piece discussing SB 6229 warned that the federal exclusion might not protect taxpayers from Washington’s tax and that “a gain fully excluded under federal law may still be taxable in Washington” (Washington State SB 6229: A Quiet but Important Change for …). The source of this tension is that Washington’s capital‑gains tax is an excise tax, not an income tax, so it is technically separate from federal income‑tax exclusions. To date, the Department of Revenue’s guidance has treated federally excluded QSBS gains as non‑taxable, but proposed bills could change that.

4. Legislative Developments to Watch

Washington’s capital‑gains tax is still in its infancy, and legislators are considering tweaks. Two bills from the 2023‑24 session—SB 6229 and HB 2292—would have explicitly included QSBS gains in the taxable base (Washington QSBS Update: SB 6229 & HB 2292 Could Tax …). Although those bills did not pass, they signal a willingness among some lawmakers to broaden the tax’s reach. Other proposals would add a higher bracket (9.9 % for gains above $1 million) or adjust the exemption threshold.
Litigation remains possible as well. When the tax was enacted, opponents challenged it as an unconstitutional income tax. Washington’s Supreme Court ultimately upheld it as an excise tax, but further legal arguments could emerge if the tax base expands. Stay tuned to updates from the legislature and Department of Revenue, and consider subscribing to alerts.

5. Planning Considerations for Founders and Investors

1. Confirm QSBS eligibility early: If you plan to rely on § 1202, work with counsel to ensure your company meets the requirements. Late fixes (e.g., converting from an LLC to a C‑corp) won’t retroactively qualify prior stock.
2. Track your holding period: The five‑year clock starts on the date you acquire the stock. If you exit before then, you may lose the federal exclusion and become subject to Washington’s 7 % tax on the full gain.
3. Monitor state‑tax changes: Because Washington’s tax is separate from federal income tax, legislative changes could decouple it from § 1202. Keep an eye on bills like SB 6229/HB 2292 and plan accordingly.
4. Consider entity choice: Forming a C‑corporation rather than an LLC taxed as a partnership can allow stockholders to qualify for QSBS. The trade‑offs include double taxation of corporate profits, but for high‑growth startups planning an eventual stock sale, the QSBS benefit can outweigh that cost.
5. Coordinate with your investors: Angel or seed investors may also qualify for QSBS. Provide them with the necessary documentation (e.g., eligibility letters) and timeline reminders so they can plan their own capital‑gains strategies.

6. Consolidating Your Existing Posts

This pillar article replaces your shorter, one‑minute updates on Washington’s millionaire tax, OBBBA revisions, and QSBS interplay. For each of those short posts:

• Retire or redirect: Edit the post to provide a one‑paragraph summary and a prominent link to this guide, or set a redirect so readers (and search engines) end up here.
• Note dated insights: If a short post contained time‑sensitive news (e.g., a court decision or legislative hearing), incorporate that as a “recent developments” section in this article or as a sidebar.
• Maintain internal links: Make sure this article links to other core resources on your site, such as your state‑conformity guide and the page for your 1202 Confirmation Services, so readers can easily navigate to related topics.

Conclusion

Washington’s capital‑gains tax adds complexity for founders and investors, particularly when combined with the powerful QSBS exclusion. At present, federally excluded QSBS gains are generally not taxed by Washington (Does Washington’s Capital Gains Tax Apply to QSBS Gains?, The OBBBA expands QSBS exclusions - Business tax), but proposed legislation could alter that. Consolidating your content into this guide will give readers a single source of truth and help build your site’s authority. By staying informed, structuring your company appropriately, and timing liquidity events carefully, you can maximize tax benefits and minimize surprises.