State statute allows a business and occupation (B&O) tax deduction for “amounts derived from investments”—unless they are “amounts received from loans” or “amounts received by a banking, lending, or security business” (RCW 82.04.4281).

Nevertheless, today the state Supreme Court held that “Businesses can claim only the deduction for investments that are incidental to the main purpose of a business.”

The majority relies on a 1986 case (O’Leary v. Dept. of Revenue) that concerned an earlier version of the statute. Before 2002, the statute excluded people “engaging in banking, loan, security, or other financial businesses” from qualifying for the deduction. (Emphasis added.) There was uncertainty about what businesses qualified as “other financial businesses.” In O’Leary, the Court said, “[w]hether an investment is ‘incidental’ to the main purpose of a business is an appropriate means of distinguishing those investments whose income should be exempted from the B & O tax.”

But the Legislature overhauled the statute in 2002 because the statute “has been the subject of uncertainty, and therefore, disagreement and litigation between taxpayers and the state.” Further, the Legislature worried that a recent Court decision “could lead to a restrictive, narrow interpretation of the deductibility of investment income.” The new statute dropped the “other financial businesses” exclusion.

The majority argues that because the new statute didn’t define “investment,” the Court’s O’Leary interpretation stands and “‘investments’ continues to mean incidental investment of surplus funds.”

Justice Gordon McCloud’s dissent (signed also by Justice Madsen) argues, “stare decisis does not require us to apply O’Leary’s restrictive interpretation of ‘investment income’ because O’Leary interpreted an older version of the statute. One way the legislature shows ‘clear and unequivocal’ intent to override a prior judicial interpretation of a statute is by ‘amending the specific section in question.’” (Emphasis in original.)

Perkins Coie has a very good overview of the case (based on the Court of Appeals decision, which the Supreme Court affirmed) here. They note that the decision “will likely have significant B&O tax impact on investment vehicles with operations (and potentially investments, investors, or beneficial owners) in Washington.”

By subjecting more investment income to the B&O tax, the decision could impact state revenues. It’s not clear at this point what the impact will be. The 2024 tax exemptions study from the Department of Revenue (DOR) provides some clues about the potential magnitude. DOR estimates that the total taxpayer savings from the investment income deduction are about $337 million in FY 2025. (See pages 147–148.)

Importantly, the report also states: “Repealing this deduction would increase revenues; however, most investment income could move out of Washington.” Given that, DOR estimates that repealing the deduction would increase state revenues by $153 million in 2025.

However, the DOR document describes this deduction as being for “businesses outside the financial sector” and DOR claims that the deduction “recognizes that incidental investment income does not constitute taxable business income.” (Emphasis added.) Consequently, it’s not clear to me whether DOR’s estimate includes the income from businesses like the ones the Supreme Court just ruled against. Further, the Court’s decision would presumably not impact all taxpayers who currently take the deduction.