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The Qualified Family-Owned Small Business Deduction

The Qualified Family-Owned Small Business Deduction

If you own or invested in a Washington state small business, you want to know about the qualified family-owned small business deduction.

And here’s why: Washington state now levies a seven-percent capital gains tax on (1) the net long-term capital gains residents realize and (2) the Washington-state-y net long-term capital gains that nonresidents realize.

But if you’re a small business owner or entrepreneur? You can probably avoid the capital gains tax on the sale of a small business.  Because the law includes a qualified family-owned small business deduction.

A warning though: Washington state’s new capital gains tax is complicated. And the most complicated bit? The small business loophole you may want to use.

The Washington Capital Gains Tax in a Nutshell

But let me briefly explain how the Washington capital gains tax works. And then I’ll get into the gritty details of the qualified family-owned small business deduction (aka, the “QFOSB” deduction.)

So the big picture on this Washington capital gains tax. The state levies a seven percent tax on the net long-term capital gains an individual taxpayer realizes.

However two wrinkles here: First, the law exempts a bunch of special-case capital gains, including most capital gains on real estate, gains from selling depreciable property, and for specific industry situations. (For a complete list of the exemptions, you can refer to a blog post over at our CPA firm website: Washington State Capital Gains Tax Planning.)

And then the second wrinkle. The law provides three deductions: A standard $250,000 deduction (so the first $250,000 of gain is never taxed). A charitable contribution deduction of up to $350,000, which is an alternative to the $250,000 standard deduction. (You would use the alternative charitable deduction only if it exceeds the standard deduction.) And then a qualified family-owned small business deduction.

Note: Those amounts in the preceding paragraph get adjusted annually for changes in the Seattle-area consumer price index. The actual standard deduction for 2023, for example, should be eight or nine percent higher.

So, that’s the big picture. But you’ll need to understand the gritty details of the QFOSB deduction.

Deduction Detail #1: Gross Revenues $10 Million or Less

A first thing to know about the QFOSB deduction: To be a small business, a firm’s worldwide revenues for the twelve-month period prior to the sale or exchange need to equal $10,000,000 or less. (This value also gets adjusted for inflation. So if you’re looking at a sale in 2023? The value might be closer to $11,000,000.)

But note that the tax doesn’t look at the capital gain, as the following two examples highlight:

Example 1: George developed and patented artificial intelligence software. After several years of development, annual revenues average less than $1,000,000 a year. But a large technology company buys his business for $100,000,000. He should qualify for the full qualified family-owned small business deduction on the $100,000,000.

Example 2: George’s wife Martha starts an ecommerce business and slowly grows the business to $12 million in revenues. After George sells his business, she sells her firm in 2022 for $500,000 based on the firm’s annual profits. (Profits roughly run $200,000 a year.) Probably half of her $500,000 of capital gains, or $250,000, gets taxed. Her business? Too big to use the QFOSB deduction on her tax return.

Deduction Detail #2: Three Families or Fewer Control

The next thing to know. The QFOSB deduction only works for an interest in a family-owned business that meets, and here I use the language of the statute, one of the following characteristics:

  • An interest as a proprietor in a business carried on as a sole proprietorship
  • An interest in a business if at least 50 percent of the business is owned, directly or indirectly, by any combination of the taxpayer or members of the taxpayer’s family.
  • An interest in a business if at least 30 percent of the business is owned, directly or indirectly, by any combination of the taxpayer or members of the taxpayer’s family and at least 70 percent of the business is owned, directly or indirectly, by the members of two families or at least 90 percent of the business is owned, directly or indirectly, by the members of three families.

The Washington capital gains tax law, by the way, says a taxpayer’s family members include ancestors (so parents and grandparents of the taxpayer, for example), spouses and state registered domestic partners, lineal descendants, lineal descendants of a taxpayer’s spouse or state registered domestic partner, and finally, the spouse or state registered domestic partner of a lineal descendant. (These definitions come from Revised Code of Washington Section 83.100.046.)

Example 3: George and his wife Martha along with their good friends John and his state registered domestic partner Abigail start a small business. Initially they each own half. Later on they sell a third of the company to a venture capital fund. If they subsequently sell the business, because their two families together own less than 70 percent, they won’t get to use the QFOSB deduction. Note that had they sold the firm before raising venture capital? Yeah, they would have qualified.

One thing to note here: The new law doesn’t define what a business is. But a reasonable guess is that the definition used for federal income taxes works. For example, the Section 162 standard established in a famous U.S. Supreme Court case, Commissioner v Groetzinger, says a business is an activity conducted in pursuit of profit and carried on with regularity and continuity. (Groetzinger was a professional gambler, by the way.)

One would think that all the common business forms “qualify” for the qualified small business interest deduction: sole proprietorships, partnerships, regular “C” corporations, S corporations, LLCs operating as a proprietorship, partnership or corporation, and so forth.

But an awkward reality: We don’t at this point know for sure how the state defines a “business.” (For example, federal income tax laws say a real estate rental activity may rise to the level of a trade or business. Yet who knows how the state sees this issue.)

Deduction Detail #3: Sell Substantially All of the Business or the Interest

Another detail you need to know to assure the deduction: The business owner needs to sell at least 90 percent of her or his interest or the owners need to sell at least 90 percent of the business’s real property, taxable personal property, and intangible personal property.

Example 4:  Washington and Adams, a land surveying partnership with two owners, sells all of the assets of their business for a $1,000,000 capital gain. The two owners share the $1,000,000 equally. Assuming all the other requirements are met, each owner shelters their proportional $500,000 gains with the QFOSB deduction because they’ve sold 100 percent of the consulting business.

Example 5: Jefferson and Burr operate a law firm as equal partners. Burr wants to sell his 50 percent interest in the law firm to a young new partner, Clinton, and then retire. When Burr sells his 50 percent interest to Clinton, he realizes a $500,000 capital gains tax and he also avoids the Washington capital gains tax on  the $500,000 gain. The reason? He sells 100% (so more than 90%) of his interest in the business.

Note: The statutory and administrative guidance available from Washington state provide no guidance on whether an existing business might be split into two or more separate businesses. For example, in Example 4, could Washington and Adams split the land survey firm into two businesses—say a Virginia operation and a Massachusetts operation—prior to the sale? And then they could possibly sell substantially all of one of those businesses? I would guess this does work. And here’s why: In  the July 2023 administrative rules’ Example 11, the Department of Revenue describes how a real estate gain potentially subject to capital gains tax can be “moved” into another entity and so escape the tax.

Deduction Detail #4: Hold Interest for Five Years

The usual time frame required to receive long-term capital gain treatment on a federal and most other state income tax returns is more than one year. But to enjoy the qualified family-owned small business deduction, a taxpayer needs to have held her or his interest in the business, either directly or beneficially, for at least five years immediately preceding the sale.  And while a mere change in the form of the business doesn’t necessarily restart the five year countdown, the change in form needs to not change the proportions of any beneficial ownership interest. (This last requirement comes from page 12 of the July 2023 administrative rules.)

Example 6:  James starts a restaurant on January 1, 2020 and operates as a sole proprietor for two years. He then incorporates the restaurant and elects Subchapter S status two years later on January 1, 2022. He sells the restaurant on December 30, 2024 and realizes a $1,000,000 capital gain. Because he sells the business one day short of five years? He will pay the capital gains tax on a portion of the $1,000,000. (Partial days count as full days per the statute. So if he’d sold on December 31, 2024 or later, he could have taken the deduction.) Note that the change in the form of the business ownership—a sole proprietorship for two years and then an S corporation for almost three years—doesn’t matter because James’ ownership percentage doesn’t change when the form of the business changes.

Example 7: John, James’s brother, also started a restaurant on January 1, 2020 and then owned and operated it for a full five years, selling the restaurant on January 1, 2025. John operated the restaurant as a sole proprietorship for the first two years and then as an S corporation the remaining three years. When he elected Subchapter S status, however, he allowed his key employee to acquire a five percent interest in the S corporation. Unfortunately, he fails to qualify for the qualified family-owned small business deduction. Why? Because his changed ownership percentage in the S corporation “form” of the business restarts the five-year holding period.

Deduction Detail #5: Taxpayer or Family Materially Participates

A material participation rule exists for the QFOSB deduction: Either the individual or a family member owning the business needs to materially participate in the business for five of the ten years immediately preceding the sale unless the sale is to another member of your family.

To determine material participation, the Washington statute basically regurgitates Section 469 of the Internal Revenue Code, which says material participation means a taxpayer needs to be involved in the operations of the activity on a regular, continuous and substantial basis. And then the statute says material participation has the roughly same meaning as the Section 469 statute and its regulations. (The actual statute says, “materially participated must be interpreted consistently with the applicable treasury regulations for Title 26 U.S.C. Section 469 of the internal revenue code…” The administrative rules then soften the “consistently” requirement with a rule to “generally” apply the 469 regulations.)

But a note: The Section 469 temporary regulations provide seven methods of achieving material participation. And only the first three methods, which set time-spent thresholds (more than 500 hours a year or more than 100 hours when no one works more or substantially all of hours), appear to work well. The regulations’ other material participation methods appear not to work. Or not to work cleanly. (Two methods, for example, say a taxpayer has materially participated for federal income tax purposes even when she or he hasn’t spent any time working in the preceding five years.)

Deduction Detail #6: Document Material Participation

A related material participation thing. Material participation from any member of the family of the taxpayer apparently counts for the entire family. But surely many family-owned small business owners have not been documenting their participation.

And for a good reason: They haven’t needed to.

Internal Revenue Code Section 469 and the companion Treasury regulations use material participation to determine when individual taxpayers claim passive activity losses and use passive activity tax credits. That’s exactly the opposite of what Washington state wants. The state uses the passive loss material participation regulations to determine if individual taxpayers report taxable income.

The practical problem in this misapplication? Profitable “qualified family-owned small business” businesses probably won’t have been tracking their material participation at least before now. Because they didn’t need to. But now they should. Probably. So they can later prove material participation.

Deduction Detail #7: Consider (Reconsider?) Activity Groupings

One other wrinkle related to Section 469 material participation rules bears mentioning.

Section 469 and its companion regulations provide a way for taxpayers to aggregate their trade or business activities into larger grouped trades or businesses.

As a generalization, trades or businesses (which is what the Washington state statute appears to talk about) might qualify for the family-owned small business deduction if they meet the requirements and follow the rules described here.

But one probably needs to stay alert to the possibility that the state says activity groupings create trades or businesses for purposes of the Washington state capital gains tax.

Example 8: Years ago, for purposes of filing his federal income tax return, Andrew appropriately grouped a warehouse he owns (held in an LLC) with a distribution business he owns (in an S corporation) based on self-rental grouping rules embedded in the Section 469 regulations. Because the IRS sees these two activities as a single activity, one wonders if the Washington Department of Revenue would see them as a single trade or business. That unintended consequence would mean that Andrew would not get a qualified family-owned small-business deduction unless he sells both the warehouse and the distribution business to the same buyer.

A related thought: Even if Andrew sold both the warehouse and distribution business simultaneously, would two sales to different buyers count as a sale or exchange that disposes of substantially all of the assets? The language of the statue talks about the “sale of substantially all of the taxpayer’s interest in a qualified family-owned small business.” Not “sales” plural, then. But a singular “sale.”

And another related thought: If the Washington Department of Revenue would see an activity grouping consisting of a warehouse and  a distribution business as a single trade or business, could the business owner first sell the warehouse? (That would presumably not trigger Washington capital gains because real estate gains are exempt from the tax.) Then later, but perhaps even in the same year, the business owner could sell substantially all of the remainder of the previously grouped activities—so just the distribution business. I would guess this works. For what it’s worth.

Deduction Detail #8: Use Smart Purchase Price Allocations

Some small businesses get sold as a collection of assets: the inventory, furniture and fixtures, maybe the real estate and then the intangible personal property like the goodwill. Because some of the assets fall into exempt income categories, a seller might want to sell assets rather than the entity.

Example 9: Martin owns a small business, Van Buren Inc., that he can sell his stock in for a $750,000 gain. However, he worries he will fail to qualify for the QFOSB deduction because he can’t confidently prove his material participation. Thus, by selling this stock, he might pay the seven percent tax on $500,000 of the gain (assuming the 2022 $250,000 standard deduction). Alternatively, in an asset sale, he can sell the inventory for a $100,000 gain (not taxed because inventory is not a capital asset), sell the depreciated furniture and fixtures for a $200,000 gain (statutorily exempt from the Washington capital gains tax), sell the real estate for a $200,000 again (again, statutorily exempt), and thus completely avoid the Washington capital gains tax.

Note: Some practitioners wondered how the Department of Revenue would handle purchase price allocations. And the July 2023 rule proposals provide helpful guidance. The proposed rules say that taxpayers can use full appraisal reports, assessor valuation if the assessment date closely matches the sale or exchange date, or the purchase price allocation the seller and buyer use to comply with IRC Section 1060. Predictably, the Department of Revenue reserves the right to change or modify what it views as an inappropriate allocation.

Deduction Detail #9: Consider Domicile of Owners

A Washington state domiciliary (basically what tax law usually thinks of as a resident) pays taxes on essentially all of her or his net long-term capital gains. (I’m ignoring the credit for taxes paid to another state if some net long-term capital gains get sourced outside Washington.)

For nonresidents, however, only tangible personal property sold or exchanged from a location in the state gets hit with the Washington capital gains tax.

Tangible personal property, per the administrative rules means “personal property that can be seen, weighed, measured, felt or touched”. Tangible personal property, then, does not include an interest in a partnership or shares of a corporation. Thus, an out-of-state small business owner might optimize by selling her or his interest in the partnership or the corporation instead of having the partnership or corporation sell its assets.

Example 10: Martin’s wife Hanna, also owns a small business, Hannah Hoes Corporation. After Martin sells his business, he and his wife move to Nevada. And then, after establishing residency there, Hannah sells her interest in her Washington corporation for a $1,000,000 gain. She avoids Washington capital gains tax.

Deduction Detail #10: Avoid Section 338(h)(10) Treatment

The modest guidance from the Department of Revenue, at least at the time we’re writing this, suggests to us that taxpayers might want to avoid common but more complex transaction structures.

As one example of this, I’d think a taxpayer wants to avoid applying Section 338(h)(10) to a qualified stock purchase transaction. Section 338(h)(10), by the way, treats a sale of stock as a sale of assets. The issue with Section 338(h)(10) is, one might not know how to handle the transaction on a Washington capital gains tax return.

Deduction Detail #11: Reconsider Section 754 Elections

A technical point.

I’m not necessarily a fan of making Section 754 elections. (The work required to make the election and then the resulting annual tax return adjustments often exceeds the tax savings.) However, taxpayers and their tax advisors probably want to reconsider Section 754 elections for appreciated property held inside a partnership at the time when a partner dies and receives a Section 1014 step-up in basis.

The reason? The step-up in basis may eliminate, or at least minimize, a taxpayer’s long-term capital gains. And that will probably eliminate or minimize Washington state’s taxation of long-term capital gains.

Deduction Detail #12: Consider Using Trust or Estate Ownership

A final, weird tangential comment: The list of pass-through entities which confer beneficial ownership for an individual excludes estates as well as trusts other than grantor trusts. That means if a nongrantor trust or estate realizes a long-term capital gain, the individuals who are beneficiaries of the estate or trust don’t pay the seven percent tax.

Thus, some small business owners may want to move an interest in a small business into a trust or sell an interest held in an estate before realizing the gain. (This gambit also works for capital assets other than interests in small businesses.)

Additional Resources for Qualified Family-Owned Small Business Deductions:

As noted earlier, we’ve got a “general” blog post over at the CPA firm website that discusses the mechanics of the Washington state capital gains tax including some common tax planning tactics: Washington State Capital Gains Tax Planning

The actual statute appears here: https://lawfilesext.leg.wa.gov/biennium/2021-22/Pdf/Bills/Senate%20Passed%20Legislature/5096-S.PL.pdf?q=20210426052154

The most recent July 2023 draft of the administrative regulation appears here: https://dor.wa.gov/sites/default/files/2023-06/20-XXXcr1frmdraftjune23.pdf?uid=64aac2f8dc5d9