Washington court denies investment funds deduction for “amounts derived from investments”

In brief

A recent Washington Court of Appeals decision, Antio LLC v. Department of Revenue, affirmed the trial court’s summary judgment in favor of the Department of Revenue (Department). The trial court had determined that a group of investment funds, operating as limited liability companies (LLCs), were not eligible to deduct “amounts derived from investments” when calculating their business and occupation (B&O) taxes. 

In affirming the lower court’s decision, the appeals court adopted the definition of “investments” established by the Washington Supreme Court’s decision in O’Leary v. Department of Revenue (O’Leary), which limited “investments” to those that were incidental to the main purpose of the taxpayer’s business. Consequently, the appeals court concluded that the LLCs were not entitled to the deduction because their investment income was not “incidental” to the main purpose of their business, but rather represented 100% of the gross income of their business.

Action steps:  Many companies have been relying on RCW 82.04.4281 when deducting investment income from their taxable Washington receipts. Given the recent decision, companies should review their investment income to determine whether their investment income exceeds the court's interpretation of “incidental” (5% of their total gross receipts).

If a company determines that their investment income exceeds the court’s incidental threshold, they should review their method of attribution and analyze whether the investment income should be sourced to Washington. In general, it might be expected that investment income would be sourced to a company’s regular place of business. However, to the extent a company’s regular place of business is outside of Washington, in some circumstances the Department has been known to apply methods that would attribute income back to Washington.

Appeals court decision

In its decision, the appeals court first disagreed with the taxpayers' assertion that there was an issue of material fact so summary judgment should be denied. The issue to be determined was whether the investment income qualified for the deduction, which is a question of law. 

The court then examined the controlling statutes. Under RCW 82.04.220(1), a taxpayer’s “gross income of the business” defined as the “value proceeding or accruing by reason of the transaction of the business engaged in” is subject to varying rates of tax depending on the business’s classification. However, the statutes provide for several exemptions from this definition, including “amounts derived from investments” under RCW 82.04.4281(1)(a). 

The primary issue was whether the taxpayers’ investments qualified as deductible “investments” under RCW 82.04.4281(1)(a) as that term has been defined or interpreted by statute, regulation or judicial precedent. The appeals court first noted that “[t]he plain language of RCW 82.04.4281(1)(a) seems to support the LLCs’ position. All of the LLCs’ income is derived from investments. This subsection does not state or even suggest that the deduction is unavailable if the main purpose of taxpayer’s business is investments. There are no limitations at all to application of the deduction in the statutory language.” 

However, the court noted that this term previously has been analyzed in the Washington Supreme Court’s O’Leary decision, which held that only investments that were “incidental to the main purpose of the taxpayer’s business … qualify for the investment income deduction.” Since all of the LLCs income was investment income, the appeals court concluded that it was not “incidental” and, therefore, did not qualify for the deduction under O’Leary.  

The taxpayers challenged the application of O’Leary on the ground that the case was decided prior to amendments to the current version of RCW 82.04.4281. The appeals court disagreed. Reviewing the legislative guidance surrounding the amendments made after the O’Leary decision, the appeals court noted that these amendments primarily were related to the term “other financial businesses,” which was first included in the 2001 statutory amendment and then subsequently removed in the 2002 amendment. Additionally, the appeals court noted that had the legislature disagreed with the supreme court’s limitation on the scope of the term “investment income” to only investment income that is incidental to the main purpose of the taxpayer’s business, it could have amended the statute. Specifically, the appeals court notes, the legislature did not provide a definition of “investment” when amending the statute. 

Finally, the appeals court disagreed with the taxpayers’ agreement that a definition of “investments” that was found on the Department’s website is “immaterial to the resolution of this case.” The appeals court noted that “documents like construction guidelines could not contradict the plain language of any applicable regulation.”