The “New” Massachusetts Estate Tax

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. Under the Federal law, the state death tax credit was reduced by 25% beginning in 2002 until it was repealed entirely in 2005. With the reduction in the state death tax credit, the states (Massachusetts among them) that used the “sponge tax” approach would 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 have been forced 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. The law actually has created a new Massachusetts estate tax. Like much tax legislation, the changes made are somewhat confusing. This new change took effect with respect to decedents dying in 2003 and later.


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causing a net loss in tax revenue because of the migration of wealthier individuals, in the early 1990s the Legislature repealed the separate estate tax and went to a sponge tax concept.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 faced after the 2001 Federal law change was the elimination of the state death tax credit. At the time, it was estimated that the state would lose between $46 million and $60 million in annual revenues that it would otherwise have collected from the sponge tax. As a result of this projected loss of revenue, the Legislature enacted the new state estate tax legislation.

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. Eventually, 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 since January 1, 2003 Massachusetts has a new separate estate tax on any estate valued in excess of $700,000, with the latter amount increased by 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.

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 change to the Massachusetts law shows us that estate tax planning is not going away just because federal tax exposures are being reduced.

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 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. Clearly estate planning and estate tax planning cannot be ignored.