Overview

Washington has long been viewed as a tax-efficient jurisdiction, historically imposing no personal income tax on individuals.¹

In 2021, the Washington State Legislature enacted a capital gains tax law, taking effect for gains realized beginning January 1, 2022.² Since Washington’s capital gains tax statute ties to federal net long term capital gain, gain excluded at the federal level generally never flowed through to Washington State.  As a result, Washington’s capital gains tax left untouched the gain from the sale of qualified small business stock (“QSBS”) excluded under Internal Revenue Code (“IRC”) section 1202.³ In other words, non-corporate taxpayers who enjoyed the federal QSBS gain exclusion also sidestepped Washington’s tax.

Washington lawmakers and budget writers now generally view this outcome as an unintended exclusion from the tax base.  Recently proposed legislation aims to tax QSBS exits partially decoupling Washington law from the QSBS exclusion.⁴

What does this mean for founders, investors, and companies?  The change represents a significant shift.  Washington residents who sell QSBS will still enjoy the federal income tax exclusion but may soon become subject to a 7 to 9.9 percent layered state tax on the sale of their shares.⁵

History of Washington’s Capital Gains Tax

Before 2021, Washington relied primarily on sales tax, business and occupation tax, and property tax, rather than income-based taxes at the individual level.⁶ In the spring of 2021, the legislature enacted Engrossed Substitute Senate Bill 5096, creating a 7 percent tax on an individual’s Washington allocated long term capital gains above a statutory threshold (initially $250,000, indexed annually for inflation).

The law immediately drew constitutional challenges.  But in March 2023, the Washington Supreme Court upheld the tax, characterizing it as an excise tax on the privilege of selling or exchanging capital assets, rather than a tax on income.⁷

Washington now imposes a 7 percent tax rate on capital gains up to $1 million.  Amounts above $1 million incur a 9.9 percent tax rate.  This creates a de facto two tier capital gains regime.⁸ There have been repeal efforts, including a 2024 ballot initiative.⁹ The efforts have so far failed, leaving policymakers focused on base broadening measures, including tightening treatment of business exits and QSBS.

Why QSBS Has Escaped Taxation Under Existing Law

The starting point for Washington’s capital gains calculation is an individual’s “federal net long term capital gain or loss,” as reported on the federal income tax return.¹⁰ The statute then applies a series of Washington specific additions, subtractions, and exclusions (including exclusions for real estate, many retirement account gains, and certain small family owned businesses).  Importantly, Washington does not recompute capital gain independently from federal law.¹¹

This linkage has been crucial for QSBS.  When a taxpayer qualifies for the IRC section 1202 exclusion, the eligible gain does not appear in federal net long term capital gain at all.  Since Washington law did not separately require an add-back of excluded QSBS gain, those amounts simply never entered the Washington tax base, even when the underlying transaction involved a very large exit.¹²

Practically, a Washington founder holding QSBS could sell $10 million of stock and claim the federal exclusion.¹³ The excluded gain did not trigger Washington capital gains tax because it never appeared in federal net long term capital gain.  Washington’s lack of a traditional income tax, combined with a capital-gains regime that respected the federal QSBS exclusion, created a strong draw for founders.¹⁴

New Proposed Bill and Goal to Tax QSBS

The recently proposed legislation focuses on two related policy goals: (1) raising additional revenue from high dollar business exits, and (2) addressing concern that major startup and closely held business gains escape the capital gains tax entirely through federal QSBS planning.¹⁵ Under this approach, Washington would effectively “decouple” from the federal QSBS exclusion requiring taxpayers to add back otherwise excluded QSBS gain when computing Washington capital gains.

The draft legislation indicates that the new law would retain the core structure of the capital gains tax, including its application to long term capital gains, and Washington source allocation.¹⁶ Legislators would also expand the list of Washington specific additions to include QSBS gain excluded under IRC section 1202.¹⁷ Under this drafted legislation, the add back is targeted at “large exit” scenarios, such that only QSBS gains above a defined dollar amount, or associated with certain equity interests, would be brought back into the Washington tax base.¹⁸

For the startup ecosystem, the practical effect is significant. Traditional QSBS planning strategies – founder stock, early relocation to Washington, long holding periods, then a QSBS eligible sale – would no longer guarantee Washington tax free treatment.  Founders and investors would need to model an additional 7 to 9.9 percent state tax on gains that previously escaped Washington taxation, while assessing timing, residency, trust structures, and entity level planning under the new rules.¹⁹

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¹ Washington Income Tax.

² Washington Capital Gains Tax.

³ 2021 Washington Tax Legislation.

⁴ Senate Bill 6229 (2026 session) (and companion House Bill 2292 (2026 session)).

⁵ Id.; New Tiered Rates for Washington’s Capital Gains Tax. Compared to California residents who similarly are subject to up to a 13.3 percent personal income tax.

⁶ A Legislative Guide to Washington’s Tax Structure.

⁷ Capital Gains Excise Tax Ruled Constitution, dated March 24, 2023.

⁸ New Tiered Rates for Washington’s Capital Gains Tax.

⁹ Washington Secretary of State, Elections & Voting; Repeal Capital Gains Tax (2024). 

¹⁰ Washington Revised Code Title 82. Excise Taxes Section 82.87.020 Definitions.

¹¹ Id.

¹² Id.

¹³ IRC section 1202.

¹⁴ Washington State Department of Revenue’s FAQ (explaining how Washington treats QSBS gains for purposes of its capital gains excise tax). 

¹⁵ Senate Bill 6229 (2026 session) ) (and companion House Bill 2292 (2026 session)) (amending the definition of “adjusted capital gain” to include gains excluded under IRC section 1202 from qualified small business stock when calculating Washington’s capital gains tax.  By bringing these formerly excluded gains into the tax base, the bill would result in the state taxing QSBS gains that are otherwise excluded for federal purposes).

¹⁶ Senate Bill 6229, sec. 1 (amending RCW 82.87.020 to retain Washington capital gains tax based on federal net long-term capital gains; allocation rules unchanged).

¹⁷ Senate Bill 6229, sec. 1 (RCW 82.87.020(1)(i), adding back IRC section 1202 QSBS gains); HB 2292 – 2025-26.

¹⁸ Id.

¹⁹ Id; Tax Year 2024 Initial Capital Gains Collections Exceed $560.6 Million.