Key Takeaways
- Court sticks with narrow definition of investment income deduction.
- Taxpayers may want to consider amending returns.
- Relocation could be an option.
A new decision from the Supreme Court of the State of Washington is making investment entities reconsider their eligibility for an important state tax benefit. Some taxpayers may need to amend returns as a result.
The Washington Supreme Court last week upheld a Washington Court of Appeals’ decision denying 16 related limited liability companies (the "LLCs") a tax deduction for "amounts derived from investments" under RCW 82.04.4281(a). This case, Antio, LLC v. Department of Revenue, addresses the interpretation of "investment income" under Washington’s Business and Occupation (B&O) tax law, creating significant implications for investment-focused businesses operating in the state.
Background and Case Summary
In Antio, the LLCs involved were structured as investment funds focused on acquiring debt instruments, such as unpaid credit card debt, to generate revenue. The LLCs claimed a B&O deduction for this income, asserting that it should qualify as “amounts derived from investments” under RCW 82.04.4281(a).
Before a 2002 amendment, RCW 82.04.4281(a) restricted this deduction to income “derived by persons, other than those engaging in banking, loan, security, or other financial businesses, from investments or the use of money as such.” Although the phrase “other financial businesses” was removed in 2002, potentially expanding eligibility for this deduction to investment-focused entities, the Washington Department of Revenue (DOR) argued against this expansion by relying on the definition of “investment income” from an earlier 1986 case, O’Leary v. Department of Revenue.
The O’Leary Case and its Influence on Investment Income Deductions
In O’Leary v. Department of Revenue, the Washington Supreme Court held that only "incidental investments of surplus funds" qualified for the B&O tax exemption. The Court reasoned that investment income must be secondary to a business's main activities and that a deduction would apply only if investment income made up less than 5% of a business’s total gross receipts.
The 2002 Amendments and the LLCs’ Argument
In 2002, RCW 82.04.4281 was amended to remove the phrase "other financial businesses" and the Antio LLCs argued that this change broadened eligibility for the deduction by allowing financial businesses to qualify, thereby superseding the O’Leary interpretation. However, the Court found that the 2002 amendment did not alter the statutory interpretation of “investment income” nor did it redefine what constitutes “incidental” investment income. The Court held that the amendment was intended only to remove the phrase "other financial businesses," without changing the fundamental requirement that the investment income be incidental to the taxpayer’s main business purpose.
The LLCs also argued that the Department of Revenue’s website supported their argument by stating, in part, “…most mutual funds, private investment funds, family trusts, and other collective investment vehicles are not a securities business and are allowed the B&O tax deduction for investment-derived amounts.” However, the trial court found that this website excerpt was not directly relevant and did not override statutory language or case law. Consequently, both the Court of Appeals and the Supreme Court disregarded this argument.
Implications and Planning Opportunities for Washington Taxpayers
The ruling has broad implications for investment-focused businesses in Washington, particularly those structured similarly to the LLCs. Washington taxpayers in financial sectors or investment funds should carefully assess their eligibility for the investment income deduction, as reliance on investment income as a primary revenue source likely disqualifies them under this new decision.
Additionally, taxpayers who previously claimed the deduction based on the Department of Revenue’s website interpretation and the 2002 amendments—similar to the Antio LLCs— may consider amending prior returns. These taxpayers may also be subject to an audit. It remains uncertain how Washington will address this issue, but taxpayers who claimed this deduction should consult their state tax advisor to determine appropriate next steps.
Conclusion
The Washington Supreme Court’s decision underscores that Washington continues to apply a narrow definition for investment income deductions, limiting eligibility to income incidental to a business’s primary purpose—specifically, investment income that constitutes less than 5% of total income.
Entities with investment income should consult with their tax advisor to assess whether amending prior returns is necessary for compliance and to explore strategic tax planning options, such as relocating to another state or restructuring revenue models.
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