The "New" Massachusetts Estate Tax
One of the changes made by The Economic Growth and Tax Relief Reconciliation Act of 2001 as part of the change to the Federal estate tax system, was a change to the state death tax credit. (See Tax and Estate Planning after the "Repeal" of the Estate Tax.) Under the Federal law, the state death tax credit is reduced by 25% beginning in 2002 and will continue to decrease by an additional 25% each year until it is repealed entirely in 2005. With the reduction in the state death tax credit, the states (Massachusetts among them) that use the "sponge tax" approach will lose a substantial amount of revenue. (The "sponge tax" is the common name for state estate taxes exactly equal to the amount of state tax the Federal government allows the estate to subtract from the tax due the United States.) As a result, many states might try to replace that lost revenue by enacting a separate estate or inheritance tax.
In fact, Massachusetts reacted to this change in the Federal law with new legislation of its own. Many people are unaware of this change because it flew in under the radar screen during the summer of 2002 when most of the political focus was on the race for governor. The law actually has created a new Massachusetts estate tax. Like much tax legislation, the changes made are somewhat confusing. This new change will be effective only with respect to decedents dying in 2003 and later.
Background
Massachusetts instituted inheritance taxes around the turn of the last century. Federal taxation of estates began in the 1920s and changed the way states approached taxation. Federal law implemented a state death tax credit to estates for obligations paid to the individual states. Federal law also created an exemption from tax for estates falling below certain defined values.
Most states then adopted a "sponge tax" that set state estate tax rates at a level equal to the state death tax credit allowed by federal law. Those states usually required only a copy of the Federal tax return to ascertain the amount of money payable to the state. Under the sponge concept, no tax was payable to any state if no tax was payable to the United States.
In addition to its sponge tax, Massachusetts continued to set a separate estate tax rate that collected substantially higher amounts than the sponge tax alone. As a result, Massachusetts was driving older people out of the state and losing tax revenues to other "sponge tax" states such as Florida and New Hampshire.
Recognizing that trying to collect a higher tax was actually causing a net loss in tax revenue because of the migration of wealthier individuals, in the early 1990s the Legislature repealed the separate estate tax and went to a sponge tax concept. Massachusetts began collecting only the amount of the state death tax credit as allowed by Federal law.
The problem that Massachusetts faces with the reduction and ultimate elimination of the state death tax credit is that the state could lose between $46 million and $60 million in 2004 if state estate taxes continue to be tied to escalating Federal exemptions. As a result of this potential loss of revenue, the Legislature enacted the new state estate tax legislation.
This new legislation will ultimately mean increased audit costs and enforcement units for the Department of Revenue in order to monitor a new estate tax system that is separate from the Federal system. The Department of Revenue does still have an estate tax unit that has reviewed older returns in the system from the 1990’s. That unit will now have to be strengthened. Presumably, the administrative costs will be significantly less than the revenue the state would lose from continuing to strictly follow the Federal system.
Other states are facing the same issue. Rhode Island has amended its law not to recognize any scheduled increase in the estate tax "exclusion amount" beyond the $675,000 amount in effect for 2000 and 2001. New York has done the same. In Florida, however, a move away from the sponge tax system could be very difficult because its state constitution prohibits an independent estate tax system. Thus, Florida may again become the desired location for many wealthy clients.
The "New" law
Initially, there was some confusion due to an ambiguity over whether the new Massachusetts estate tax (which is still tied to the Federal state death tax credit) would be "frozen" in time or tied to the federal "unified credit," which increases over time. At the end of October, the Legislature clarified most of the confusion by making it clear that all references to the Internal Revenue Code would be to the Code as in effect on December 31, 2000. What this means is that as of January 1, 2003 Massachusetts will now have a new separate estate tax on any estate valued in excess of $700,000, the "old" Federal estate tax phase-in rules.
The "old" Federal estate tax rules (i.e., the law in effect on December 31, 2000) contemplated a gradual "phase-in" of higher exemption levels from the "old" amount of $600,000 to $1,000,000 by the year 2006. According to the "old" Federal estate tax rules, the exemption was to increase to $700,000 for 2002 and 2003, $850,000 for 2004, $950,000 for 2005, and $1,000,000 for 2006. These exemption increases will continue to be the threshold for the new Massachusetts estate tax.
An example of how this change will impact taxpayers may be helpful. If a Massachusetts resident dies during 2003 with a "taxable" estate of $1,000,000, no Federal estate tax will be owed. But now, there will be a Massachusetts estate tax owed of approximately $33,200. If there would have been no Federal tax under the Internal Revenue Code of 2000, there will be no Massachusetts tax. Thus, with the optimum use of the marital deduction, no tax will be due to Massachusetts in the case of a married person irrespective of the size of the estate.
Future Planning
Once again many wealthier clients will have to consider changing their domiciles to "friendlier" locales just as they did when Massachusetts had higher estate taxes many years ago.
Certainly, this new change to the Massachusetts law shows us that estate tax planning is not going away just because federal tax exposures are being eliminated.
Another planning option is to increase lifetime gifts. Lifetime gifts could reduce state estate taxes under this new taxing scheme because the estate tax owed to Massachusetts would be computed on taxable estates only and any lifetime gifts ("adjusted taxable gifts") are not taking into consideration when computing the state death tax credit. Gifting, however, has certain downsides as the donee generally assumes the same cost basis that the donor had in the asset gifted which could cause a bigger future capital gain for income tax purposes.
These new changes will make estate planning even more complicated as more variables will have to be taken into account, e.g., potential divergences between Federal and state estate tax rules, the scheduled estate tax "exclusion amount" for any particular year, the pros and cons of making gifts to reduce or eliminate the potential Massachusetts estate tax in light of the carry over basis rules, etc. And while it may be even more likely that the ultimate elimination of the Federal estate tax will be confirmed, given the Republican victories in Congress, clearly estate planning and estate tax planning cannot be ignored.