Seattle’s New Income Tax May Affect Many More People Than Initially Thought, Including People Living Outside the City

When Seattle passed its new income tax on July 10, many Washingtonians took note, but quickly moved on. The tax appeared to apply only to Seattle residents earning more than $250,000 for individuals or $500,000 for married couples, so many simply assumed that this tax would not apply to them. However, some unique provisions in the law are set to affect people living outside of Seattle and many Seattle residents who do not identify as part of the “One Percent.”

First, individuals who have never lived or worked in Seattle may feel the impact of the new income tax if they are beneficiaries of trusts established by Seattle residents. Under Seattle’s new income tax, certain trusts are subject to tax on the income they generate (including capital gain on the sale of investments and real estate). It does not matter where the trustee or the beneficiaries live: If the grantor (the person who put property into the trust) was a Seattle resident when the grantor put the property into an irrevocable trust, or if the grantor was a Seattle resident when the trust became irrevocable, the income of the trust is subject to tax and it owes 2.25% of the income above $250,000 for the tax year. This means that the tax will apply to irrevocable trusts, such as life insurance trusts and residential trusts, created by Seattle residents, even if the beneficiaries of those trusts are not residents of Seattle.

There is a similar issue for revocable living trusts. For example, assume that a married couple put their home and investments into a revocable living trust, with their grandchildren as the beneficiaries. They are Seattle residents when they die and the trust becomes irrevocable. In this situation, after January 1, 2018, the trust would owe Seattle income tax on the gain or income generated by the trust assets (the investments and the home). Like the irrevocable trusts, the Seattle’s income tax applies to the trust even if the grandchildren lived outside Seattle their entire lives. Because many trusts are established for estate planning purposes, and are not limited to high net worth individuals, many individuals who do not consider themselves wealthy could feel the economic impact of Seattle’s income tax when it comes time to deal with a trust established by a Seattle resident.

Second, the tax could hit many longtime Seattle home owners. The capital gains on home sales are taxable, except to the extent the home sale exclusion applies. While the home sale exclusion generally applies to gains up to $250,000 ($500,000 if married filing jointly), the Seattle real estate market makes it fairly easy to reach these thresholds, as more than one-half of Seattle homes are worth more than $730,000. In addition, some residents may not satisfy the requirements of the home sale exclusion. For example, a person who moved to Seattle from Tacoma during the Great Recession, and rented out their home or condo in Tacoma instead of selling it at a loss, might not even qualify for the home sale exclusion if they sell their house today.

When Seattle analyzed 2014 income tax data to set the income tax thresholds, it determined that only approximately 8,500 households would be affected by the tax. This analysis did not take into account the number of trusts that would be subject to the tax, or reflect the fact that many taxpayers who filed in one year will not be filing in the next. A 2010 study found that between 1999 and 2007, approximately one-half of taxpayers earning more than one million dollars did so only for one year.[1]  In other words, the “millionaires” received a large sum of money for only one year. While the study did not go into details, this makes sense as many people selling long-term assets (homes, stocks, businesses, etc.) would be counted as “millionaires” solely for the year of that transaction. The same phenomenon will likely drive the number of taxpayers who owe Seattle’s income tax at least once over the next few years significantly above the city’s initial estimate.

Fairly common events may trigger Seattle’s income tax, such as the sale of appreciated assets or the use of a typical irrevocable trust for estate planning purposes.  If you have questions regarding the effect of this tax on your financial or estate planning, please contact one of the key contributors listed on this alert.

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