Washington State Business & Occupation Tax Exemption on Investment Income

The Washington Business & Occupation (B&O) tax applies to any business entity with sufficient sales sourced to the state of Washington and is imposed on the gross receipts of the entity in the state, generally with minimal or no deductions when computing the tax. However, properly categorized investment income can be deducted (effectively excluded from) the tax base. Since this exclusion from the tax base was written into law in 1980, it has been subject to significant change, as well as extensive litigation and legal interpretations.

Explanation and History of the Law

Washington Rev. Code Section 82.04.4281 allows income derived from investments, dividends, capital distributions and a limited amount of interest on intercompany loans to be deducted and excluded from the tax base. Prior to July 2002, the law allowed for a deduction on “amounts derived from investments,” except for banks, lenders, securities dealers and “other financial businesses” that were generally not permitted to exclude these types of income.

In 2002, the state removed the term “other financial businesses” from the exclusion to eliminate ambiguity over what types of income could be excluded from the B&O tax base in light of the Washington Supreme Court’s decision in Simpson Investment Co. v. Washington Department of Revenue (141 Was 2d 139 (2000)). The Court determined in this case that a holding company of four different manufacturing subsidiaries was considered a “financial business” (but not a bank, lender or securities dealer) and denied them the exclusion it sought on its income from investing. Because of this decision, the state regarded the term “other financial businesses” as too broad and overreaching and believed that removing these words would improve the state’s overall business climate. There was fear that the Simpson Investment Co. decision would lead to stricter interpretations of the law and further limits to the exclusion, resulting in business entities other than financial companies being taxed on such income. Since this 2002 change, however, this B&O tax exclusion has been understood as generally applicable to all types of investment income, outside of investment income received by banks, lenders and securities dealers.

In a case decided late last year, Antio, LLC et al v. Washington State Department of Revenue (557 P3d 672, (10/24/2024)), the Washington Supreme Court held that the statutory phrase “amounts derived from investments” could not be broadly interpreted to mean any kind of investment income realized by a business. Rather, the case emphasized a much earlier court decision, O’Leary v. Department of Revenue (105 Wash 2d 679 (1986)), which defined “investments” as the “incidental investment of surplus funds.” The taxpayers in Antio were investment funds that were not considered banks, lenders or securities dealers that derived all their income from investing in debt instruments. These taxpayers attempted to exempt all of their income from the B&O tax under the premise that all of it could be considered non-taxable “investment income.”

The Court disagreed and ruled that, as decided in the O’Leary case, only the income coming from investments outside of and incidental to the core business of the taxpayer could be considered “investment income” to be excluded from the B&O tax base. The plaintiff in Antio could not exclude income from the purchase and sale of debt instruments because allowing them to do so would have run counter to the O’Leary decision, which had interpreted the statute to only permit the deduction of income from the “incidental investment of surplus funds.” The court indicated the state was not prevented from restricting exactly what type of income could be excluded from the B&O tax base, regardless of what kind of business generated the income.

Most importantly, the Antio decision clarified exactly what types of entities could exempt investment income and what types of income could be exempted. Furthermore, the decision established that the 2002 change to the law was not meant to override the O’Leary case ruling. Rather, the change was designed to ensure that the exemption on investment income, within certain parameters, is available to all business entities other than banks, lenders or securities dealers, provided the business could show the claimed investment income was merely incidental to its primary sources of income.

How the Laws and Court Decisions Affect Your Business

If your business derives multiple types of revenue from Washington state, including potential “investment income,” you need to determine whether and to what extent the investment income is from the “incidental investment of surplus funds” or from your core business. While the state has not readily defined what funds generated by a business can be considered “incidental” or “surplus funds,” on Jan. 14, 2025 the Washington Department of Revenue issued guidance stating that it “will presume that an investment activity is not the main activity of a taxpayer (and is thus deductible from the tax base) if it generated less than 5% of the taxpayer’s annual gross receipts.”

The guidance further states that the 5% of gross receipts measure is a “safe harbor,” and when taxpayers claim a deduction in excess of this safe harbor, they:

Must establish that the income was generated from an incidental investment of the taxpayer’s surplus funds. In this regard, in determining whether investment activity is incidental, a taxpayer’s facts and circumstances at and prior to the time of filing will be relevant.

Aside from confirming that banks, lenders and securities dealers are not eligible for the deduction for investment income, the Department provided that it was considering providing further guidance on how mutual funds, private investment funds, family trusts and other entities regarded as investment vehicles would be treated for tax purposes. No further insight on this exemption is indicated in the recent guidance.

Based on prior case law, it appears that the state would likely exclude any income a business generates from investing funds outside its normal course of business. This could include interest, dividend or capital gains income using profits that are not invested back into the core business. Based on the Jan. 14, 2025, guidance, business entities can deduct any income from investment activity amounting to less than 5% of their total gross receipts.

For example, a company that generates 95% or more of its income from stock options (through trading on its own account), with the rest coming from money market interest on its excess funds, may be able to exclude the money market income.

Obviously, this issue gets trickier for a business that generates its primary income from investing in different types of financial instruments because of the difficulty in determining what is outside of its core operations. Until the state establishes a clear definition of “incidental,” companies that are mainly focused on generating income from securitized investments should exercise caution in claiming an exclusion from the B&O tax on investment income.

Until a clearer definition of “incidental” or “surplus funds” emerges in Washington, or the state’s Department of Revenue issues guidance on potential exemptions for business entities that are not bankers, lenders or securities dealers (but who generate most of their income from investing), such types of entities may not want to take any deduction. Alternatively, they may want to consider obtaining a private letter ruling from the Department on this matter.

Have Questions?

If you have any questions or need more information about the Washington State Business & Occupation Tax Exemption on investment income, connect with the CBIZ SALT team today.