Washington’s New 9.9% Income Tax: Tax-Efficient Business Sales and M&A Deals

Key Takeaways

• Tax Rate and Threshold: A 9.9% flat tax applies to individuals or households with Washington taxable income of $1,000,000 or more.
• Taxpayers covered:  A married couple or persons in a state-registered domestic partnership share a $1 million deduction regardless of federal filing status.  Other individuals have separate $1 million deductions.
• Effective Date: January 1, 2028.
• Business Sale Impact: Asset sales may trigger higher taxes than equity sales because ordinary income (like non-compete payments) lacks the exemptions and credits available to capital gains.
• QSBS Protection: Gains excluded from federal income under IRC 1202 generally remain exempt from this state income tax. For stock acquired after July 4, 2025, federal law allows partial tax exclusions starting after three years (50%) and four years (75%), with a 100% exclusion after five. The exclusion cap is now $15 million or 10 times the taxpayer’s basis.
• Executive Compensation:  Qualified and non-qualified deferred compensation arrangements for key employees that defer recognition until an executive or employee is no longer a Washington resident will become more important.
• Double Tax Prevention: The law credits Washington capital gains and B&O taxes paid on the same income. These nonrefundable credits reduce the income tax hit dollar-for-dollar by the amount of the specific tax already paid.

______________________________________________________________________________

Overview

As Washington’s tax landscape undergoes its most significant transformation in decades, business owners and high-net-worth individuals must prepare for a more punitive and complex regulatory environment. During the 2026 Washington State legislative session, Washington State’s house and senate approved Engrossed Substitute Senate Bill 6346, commonly known as the “Millionaires’ Tax” (“Income Tax”). The Income Tax adds a new layer to a state-level system that already includes a robust capital gains tax (“Capital Gains Tax”). 

As of the date of this publication, the Income Tax has been delivered to and awaits signature by Governor Bob Ferguson, who has indicated that he would sign the Income Tax into law. He is anticipated to do so on or before the April 4 deadline. 

If enacted, the Income Tax would represent a dramatic reversal that is difficult to overstate. Washington will move from being one of only nine states without a general income tax (although it previously adopted a capital gains income tax) to having the sixth-highest top rate in the nation, surpassing traditionally high-tax states like Massachusetts, Vermont, and Connecticut. For those planning a business exit or other major income recognition event, understanding how Washington’s taxes interact with federal income taxes is no longer optional; it is a critical deal component.

Mechanics of the New “Millionaires’ Tax”

The new legislation imposes a 9.9% flat tax on all Washington taxable income, effective January 1, 2028. The Income Tax incorporates federal adjusted gross income (“AGI”), with certain modifications (e.g. excluding federal long-term capital gains then adding back Washington capital gains tax and applicable deductions), with the effect that most income recognized on a federal return, including wages, interest, and business earnings, flows directly into the state tax calculation. 

The Income Tax includes a standard $1 million deduction from federal AGI to target households or individuals with income exceeding $1 million. The Income Tax applies to residents on income from all sources and to nonresidents on income derived specifically from Washington sources. While the Income Tax does not tax corporations directly, it does tax “pass-through” income from LLCs, S-corporations, and partnerships at the individual level, once the taxpayer’s total income crosses the $ million threshold.

Key Exemptions

The Income Tax contains the following exemptions:

• Real Estate: The Income Tax excludes the sale of real property from the calculation of taxable income by incorporating the exemptions contained in the Capital Gains Tax. This means gains from the sale of real estate or interests in real estate do not count toward the $1 million threshold. 

• Qualified Family-Owned Small Businesses: Consistent with the Capital Gains Tax, the Income Tax also provides an exemption for the sale of “qualified family-owned small businesses” as such term is defined under the Capital Gains Tax. To qualify for this exemption, among other requirements, the seller must have held a qualifying interest in a business for at least five years, and the business must have generated less than an inflation-adjusted limit of approximately $11 million in worldwide gross revenue during the 12-month period preceding the sale.  See below on the increased importance of §1202 under Washington’s new, expansive tax regime.

The Interplay: Capital Gains, B&O, and other Taxes

A primary concern for sellers is the potential for “double taxation.” The legislation addresses this through a series of nonrefundable credits:

• Capital Gains Tax: For transactions exceeding $1 million, the Washington Capital Gains Tax rate is 9.9% (7% for taxable gains under $1 million). To prevent taxpayers from paying both taxes on the same proceeds, the law credits Washington Capital Gains Taxes paid against the new Income Tax liability. This credit reduces the Income Tax hit by the exact dollar amount of the Capital Gains Tax paid on that same income.

• B&O and Other Taxes: Similarly, to avoid taxing the same business income twice, the law credits the income tax for any Business and Occupation (“B&O”) or public utility taxes paid. This credit equals the specific amount of tax paid under those chapters for income included in both calculations, effectively eliminating the state income tax on that portion of the earnings.

____________________________________

Business Sales and M&A

The shift from an income tax-free state to one with multiple high-rate income taxes means that the structure and drafting of business sales now carry immense financial weight. Basic deal structure (i.e., asset vs equity sale), already a critical decision for federal income tax and state sales tax purposes (among other important legal considerations), now carries state-level income tax consequences that can shift take-home proceeds by six or seven figures.  Earn-outs and other deferred payments to owners and key personnel will also take on added importance.

The Power of QSBS (IRC 1202) in Washington

Leveraging Qualified Small Business Stock (“QSBS”) under Internal Revenue Code Section 1202, already useful, will become a critical tool for Washington taxpayers to reduce taxes on business sale proceeds. Because Washington’s new Income Tax uses AGI as its starting point, any gain that is successfully excluded from federal income is generally shielded from the 9.9% state Income Tax as well. This makes QSBS incredibly valuable. If a business qualifies, a stock sale allows the stockholder to exclude a significant portion of the gain from both federal and state income taxes. The law now permits a 50% exclusion after only three years and a 75% exclusion after four years, with the full 100% exclusion still available after five years, for certain QSBS stock. Additionally, the per-issuer gain exclusion cap recently increased to $15 million (or 10 times basis, whichever is greater), and this $15 million limit now indexes for inflation annually. Flatly, maintaining a company’s “qualified” status throughout its lifecycle is now one of the most valuable long-term tax strategies available to Washington founders.

At the same time, Washington taxpayers should be aware that the state legislature has already considered proposals to disallow the Section 1202 exclusion for purposes of the Capital Gains Tax, which would significantly narrow the state‑level benefit of QSBS even if federal law remains favorable. Given this legislative history, we expect continued scrutiny of QSBS planning in Olympia and will be monitoring future sessions closely.

C-Corporation Conversions in Light of QSBS

Relatedly, founders and existing owners of entities taxed as disregarded entities, partnerships, or subchapter “S” corporations who are evaluating QSBS‑driven planning, should consider conversion to C-corporation status under Washington’s new regime. A properly structured conversion that results in newly issued stock can start the QSBS holding period clock, with an eye toward achieving a partial or full federal exclusion and, under current law, avoiding inclusion of that gain in the Washington Income Tax base. That said, C‑corporation status introduces its own trade‑offs, including federal double taxation, potential state‑level B&O tax considerations, and the risk that Washington may later curtail QSBS benefits for Capital Gains Tax or Income Tax purposes. Any decision to convert should therefore be accompanied by careful modeling of expected growth, holding period, exit scenarios, and the likelihood that future legislative changes could erode the anticipated QSBS benefit.

Preventing Double Taxation on Deal Proceeds

Sellers often worry the state will hit the same dollar with both the 9.9% Capital Gains Tax and the 9.9% Income Tax. To prevent this, the Income Tax credits Washington Capital Gains Taxes paid against Income Tax liability. This nonrefundable credit reduces a taxpayer’s Income Tax hit dollar-for-dollar by the amount of Capital Gains Tax already paid on the same income. The taxpayer pays the higher of the two taxes, rather than both combined. While this provides a necessary “safety net,” the credit only applies to income characterized as a capital gain. Because the two taxes use different definitions for what qualifies as “taxable,” deal purchase agreements must be drafted carefully to ensure that proceeds qualify for this credit and avoid a “double tax” trap.

Equity Sales Are More Compelling Than Ever for Sellers

Both the Capital Gains Tax (assuming the maximum rate) and the Income Tax feature a 9.9% rate, which might appear to render the asset vs. equity question a wash, at least for state tax purposes. However, the availability of exemptions makes an equity deal much more compelling. In an equity sale, the entire profit typically qualifies as a capital gain, allowing the taxpayer to claim double-tax credits and powerful exemptions such as QSBS or the Family-Owned Business deduction. In an asset sale, however, the parties must allocate the purchase price across different categories. Portions allocated to inventory, “recaptured” depreciation, or non-compete agreements count as ordinary income. Please note that Washington State’s recent ban of noncompetition agreements does not extend to noncompete agreements entered into in connection with the purchase or sale of more than 1% of a business. Because ordinary income does not trigger the 9.9% Washington Capital Gains Tax, the taxpayer has no capital gains tax to pay and therefore no credit to apply against the 9.9% Income Tax bill. Consequently, sellers must negotiate purchase price allocations that aggressively favor capital gains to preserve the protections that asset sales otherwise strip away.

Please see the following illustrative example, highlighting the impact of selling equity, not assets, in the context of a small business sale. The example makes certain assumptions and approximations for the sake of this illustration, including cash at close, long-term gains treatment, use of the small family business exemption, higher-than-usual allocation to ordinary income assets, and others.

Mitigation Strategies: Timing and Structure

Beyond the above, more sophisticated structures can provide additional relief:

• Rollover Equity: If the taxpayer “rolls over” a portion of his or her ownership into the buyer’s new entity, the taxpayer can often defer both federal and state taxes on that portion until a future sale.

• Installment Sales and Earn-outs: The timing of gain recognition is critical. Because the new income tax begins in 2028, a sale closed in 2027 with an “earn-out” payment in 2028 could inadvertently trigger the new tax on those later proceeds. Careful drafting can control the timing of this recognition and avoid the Income Tax entirely.

• Getting the heck out of Dodge – Trust Planning and Redomiciling: Some high-net-worth individuals, or business owners planning an exit, may consider redomiciling to a tax-free (or lower tax) state or using complex trust structures to house their assets. However, Washington’s residency rules are strict, and breaking domicile requires severing significant ties. Maintaining a domicile in the state of Washington or maintaining a place of abode in Washington and spending more than 183 days in the state, among other missteps, can still trigger “resident” status for tax purposes. Please contact PRKL attorneys for more detail regarding these strategies.  Domicile is also a critical factor in Washington’s estate tax.

Non-Transactional Planning Under the “Millionaire’s Tax”

Even outside a specific transaction, high‑income Washington residents will need to evaluate new planning tools and pressure points under the Income Tax.

• Pass‑Through Entity (PTE)‑Level Taxation: One potential strategy is to consider an elective pass‑through entity‑level income tax (if enacted by the legislature) that may create offsetting federal deductions for owners while managing Washington‑source income allocations; similar elective PTE taxes already exist in numerous other states as a response to the federal SALT deduction cap.

• Charitable Deductions: Strategic charitable contributions, especially of appreciated assets like QSBS or long-term capital gain property, can reduce both federal AGI (and thus Washington Income Tax) and Washington Capital Gains Tax exposure, since the taxes start from a modified AGI base and follow federal deduction rules. Donors should time gifts to align with high-income years and consider donor-advised funds for flexibility.

• Cash Balance 401(k) Plans: Adopting or expanding a cash balance 401(k) plan can meaningfully reduce AGI by increasing deductible retirement contributions. For some high‑earners and businesses, this may help keep income below, or minimize income above, the $1 million threshold.

• $1 Million Threshold Penalizes High-Earning Couples: The Income Tax’s $1 million deduction applies per “household”, not per person, which means a married couple filing jointly has the same threshold as an unmarried individual, not in a registered domestic partnership. High‑earning couples, particularly dual‑income households, may therefore be penalized compared to two unmarried individuals with similar combined earnings, and should carefully consider filing‑status and income‑timing strategies in light of this structure.

Closing Thoughts: The Necessity of Early Planning

The complexity and punitive nature of Washington’s new tax regime mean that legal and tax planning cannot wait until the “closing” phase of a deal; rather, strategies to mitigate the effects of the Income Tax and the Capital Gains Tax must be incorporated at the letter-of-intent stage and even at entity formation. Once the broad strokes of a deal are signed, it is often too late to re-characterize income or change the timing of a payout. By integrating legal and tax counsel early in the process, sellers can ensure that the transaction documents are drafted to protect their hard-earned equity from unnecessary state tax exposure.

Contact Us

If you have any questions or need our help navigating Washington’s new tax system, the PRK Livengood business team is ready and available to help.