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

This post is part of our Complete Guide to QSBS and Section 1202.

This post is part of our Complete Guide to Washington's New Income Tax.

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 (for pre-OBBBA stock) or $15 million (for stock issued after July 4, 2025) — or ten times basis, whichever is greater — 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: The standard deduction is indexed annually for inflation — $278,000 for 2025. Long‑term capital gains above the standard deduction are taxed under a tiered rate structure enacted by SB 5813 (signed by Governor Ferguson on May 20, 2025, retroactive to January 1, 2025): 7% on gains between the standard deduction and $1 million, and 9.9% on gains exceeding $1 million. The $1 million threshold is not indexed for inflation.
• 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 Washington Supreme Court upheld the tax as a constitutional excise (not a property tax on income) in Quinn v. State, 1 Wn.3d 453, 526 P.3d 1 (2023), and the U.S. Supreme Court denied certiorari in January 2024. The tax is now in effect and 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 at or below the applicable threshold at the time of and immediately after issuance — $50 million for stock issued on or before July 4, 2025, or $75 million for stock issued after that date (indexed for inflation beginning in 2027) under the OBBBA.
• 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: For stock issued on or before July 4, 2025, the taxpayer must hold the stock for more than five years to claim any exclusion. For stock issued after July 4, 2025, the OBBBA introduced a tiered exclusion: 50% at three years, 75% at four years, and 100% at five years. The unexcluded portion is taxed at the 28% §1(h)(4) rate plus the 3.8% NIIT; the excluded portion remains NIIT-exempt under §1411(c)(1)(A)(iii).
• 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: The per‑issuer cap is the greater of $10 million (for stock issued on or before July 4, 2025) or $15 million (for stock issued after July 4, 2025, indexed for inflation beginning in 2027) — or ten times the taxpayer's adjusted basis in the stock, whichever is greater. Earlier issuance dates (pre‑September 28, 2010) carry only 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. Washington's capital‑gains tax piggybacks on the federal definition of capital gain and does not tax gains the federal government has already excluded under § 1202. So a Seattle founder who sells stock for a $20 million gain and excludes $15 million under § 1202 would owe Washington capital‑gains tax only on the remaining $5 million (after the standard deduction and the 7%/9.9% tiered rate apply).

The mechanism is straightforward: Washington computes its tax by starting from the taxpayer's federal long-term capital gain as reported on the federal return. Gains excluded under § 1202 never appear in that federal number—they are excluded before the return is filed. Because Washington derives its tax base from that same figure, federally excluded QSBS gains simply are not in the starting number that Washington taxes. There is no separate Washington-level exclusion needed; the gain is already gone from the base.

That said, this is statutory conformity, not constitutional protection. Nothing in Washington's constitution requires it to piggyback on federal AGI, and the legislature can change that at any time. SB 6229 in the 2026 session would have done exactly that—explicitly adding back federally excluded QSBS gains into the Washington tax base. It did not pass, but it came close enough to treat as a genuine warning shot.

4. Legislative Developments to Watch

Washington's capital‑gains tax has been actively modified since enactment, and further changes remain possible. The most recent major change was SB 5813 (2025), which added the 9.9% tier on gains above $1 million retroactive to January 1, 2025. In the 2026 legislative session, SB 6229 (and its companion HB 2292) would have explicitly added a state‑level QSBS add‑back, effectively taxing federally excluded QSBS gains. Those bills did not pass, but they signal continuing legislative interest in broadening the tax base. Stay tuned to updates from the legislature and the Department of Revenue.

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. In practice, this means auditing your C-corp status, asset test, active business use, and original-issuance records before you are anywhere near an exit—not when a term sheet arrives. Buyers and their tax counsel will ask for this documentation in due diligence, and gaps that could have been fixed years earlier often cannot be fixed then.
2. Track your holding period: The holding period clock starts on the date you acquire the stock. For pre‑OBBBA stock (issued on or before July 4, 2025), you need more than five years for any exclusion; for post‑OBBBA stock, partial exclusions kick in at three and four years. If an exit comes too soon, a § 1045 rollover into replacement QSBS within 60 days can preserve the § 1202 holding period clock. A § 1045 rollover works like this: instead of selling and triggering gain, you roll the proceeds into stock of another qualified small business within 60 days. The new stock inherits the holding period from the original, so the five-year clock keeps running rather than restarting. This is particularly relevant in Washington because any gain you do recognize—the portion that falls outside the § 1202 exclusion or that fails the holding period—immediately becomes subject to Washington's 7% or 9.9% tax. Any non‑excluded gain falls back into Washington's capital‑gains tax base, where the 7%/9.9% tiered rates apply.
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. To see why: a C-corp paying 21% federal corporate tax on $1 million in profits incurs roughly $210,000 in entity-level tax annually. At exit, a founder holding QSBS who qualifies for the full § 1202 exclusion eliminates federal tax on up to $15 million of gain—a benefit worth $3 million or more at current federal rates, plus Washington's 7–9.9% on whatever remains. For a startup that stays small and profitable but never sells, the double-taxation cost is real; for a venture-scale company targeting a large exit, the QSBS math almost always wins.
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. Concretely: at or shortly after issuance, send each investor a written confirmation that the stock qualifies as QSBS under § 1202 as of the date of issuance, including the company's gross asset value immediately before and after the investment. Note the issuance date clearly—investors will need it to track their own five-year holding period. If you are approaching a potential exit and investors are nearing the threshold, a proactive reminder of their holding period status and any § 1045 options can prevent costly mistimed sales.

Conclusion

Right now, Washington and QSBS work together in your favor: gains excluded federally under § 1202 never enter Washington's tax base, so a well-structured exit can eliminate both federal and state capital-gains tax on millions of dollars of proceeds. That is a genuinely powerful result—but it rests on a single legislative decision that could be reversed in any session with little warning. SB 6229 in 2026 was not a fringe proposal; it had serious sponsors and came closer than many founders realize. The practical takeaway is this: the time to get QSBS right is not when a term sheet arrives, but years before—when you choose your entity, when you issue stock, and when you document eligibility for every investor. The benefit is available now; the risk of losing it is real and growing.

For a comprehensive planning guide, see the Washington State Tax Planning Guide for High Earners ($49.99)..

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