Co-written by: Karen Witherell
Published in SUMNEWS Winter II 2015 (a publication by Massachusetts Society of CPAs)
Prior to the current Massachusetts estate tax system, Massachusetts was a "sponge tax" state, where the Massachusetts estate tax was directly linked to the federal estate tax.
Following the Federal Economìc Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which gradually phased out the federal estate tax and completely eliminated it for 2010, the Massachusetts estate tax was "decoupled" from the Federal estate tax, effective for estates of decedents dying on or after January 1,2003. For estates of decedents dying on or after the effective date, the Massachusetts estate tax is equal to the credit for state death taxes computed using the Internal Revenue Code in effect on December 31, 2000.
In 2015, the federal estate and gift tax exemption amount is $5.43 million and the tax rate is 40 percent allowing for the transfer of property during life or upon death of up to $5.43 million with no federal estate or gift tax. In addition, surviving spouses may "port" any unused exemption from the deceased spouse's estate for use in the surviving spouse’s estate. Due to the increase in the federal estate and gilt tax exemption and the availability of portability, fewer estates are subject to exposure to federal gift tax or federal estate tax.
Massachusetts, however does not have a gift tax and has only a $ I million filing threshold for estate tax purposes. Further, portability ìs not recognized for Massachusetts estate tax purposes. The significantly lower exemption amount and lack of portability results in many Massachusetts estates being subject to Massachusetts estate tax, while not being subject to federal estate tax.
Because the Massachusetts estate tax is equal to the federal credit for state death taxes in effect on December 31, 2000, the tax is calculated using the federal estate tax return (Form 706) for 1999. For purposes of calculating the Massachusetts estate tax, the relevant lines of the 1 999 Form 706 are as follows:
Line 3 – Taxable estate;
Line 4 – Adjusted Taxable Gifts; and
Line 15 – Credit for state death taxes
To determine whether or not the $1 million filing threshold has been met, the amount of the taxable estate plus the amount of lifetime adjusted taxable gift (lines 3 and 4, respectively) must be calculated. Although Massachusetts does not have its own gifts tax, adjusted Federal taxable lifetime gifts are taken into account for purposes of determining whether the $1 million filing threshold has been met.
Unlike the federal estate tax (in which the tax applies to amounts in excess of the exemption amount), once the filing threshold has been met in Massachusetts, the full value of the estate (less $60,000) is subject to Massachusetts estate tax at rates between 0.8 percent and 16 percent.
The credit for state death taxes (i.e. the amount of Massachusetts estate tax that actually must be paid) on the 1999 Form 706, however, is calculated "by using the amount on line 3 less $60,000." See 1999 United States Estate (and Generation Skipping Transfer) Tax Return (IRS Form 706), line 15. Therefore, adjusted taxable gifts are not taken into account when calculating the credit for state death tax.
So while adjusted taxable gifts might necessitate the filing of a Massachusetts estate tax return, such gifts will not be taken into account when calculating the actual Massachusetts estate tax liability. This allows a person to make significant lifetime gifts (even deathbed gifts) to reduce Massachusetts estate tax. And although the donor may need to file a federal gift tax return if lifetime gifts are made, there will be no federal gift or estate tax consequence if the donor ‘s gross estate is well below the federal exemption amount.
For example, a $2.5 million estate would generate a Massachusetts estate tax of $138,800. If a $500,000 gift was made prior to death reducing the estate to $2 million, the Massachusetts estate tax would be $99,600, resulting in Massachusetts estate tax savings of $39,200. If a gift of $2 million was made prior to death reducing the estate to $500,000, the Massachusetts estate tax would be $10,000, resulting in an even greater Massachusetts estate tax savings of $128,800.
It is important to note that only adjusted taxable gifts are considered when determining whether the filing threshold is met. Annual gift tax exclusion gifts (currently $14,000 per recipient) can reduce the amount of the taxable estate and are not taken into account when determining whether the filing threshold is met. Therefore, Massachusetts estate tax savings can be achieved as a result of simple annual gift tax exclusion gifts, which do not require any form of gift tax filing. For example. if a Massachusetts resident with an estate of $1,559,000 makes annual exclusion gifts to her four children and six grandchildren during the four years prior to death (`or a total of$560,000), the decedent's estate is $999,000 at death. Because the annual exclusion gifts are not considered when determining whether the filing threshold is met, no estate tax return is required. In this example, the Massachusetts estate tax savings is $68,176.
When utilizing lifetime gifting to reduce Massachusetts estate tax, it is important to also analyze the income tax consequences of such gifting to determine whether e net tax benefit will be achieved.
When a donor makes a lifetime gift, the donee receives the donor's tax basis in the asset (carryover basis). Gifting low basis assets, therefore, can subject the donee to significant capital gains taxes upon the donee’s sale of the assets. Between the Massachusetts long-term capital gains tax of 5.2 percent and the federal long-term capital gains tax of 15 percent or 20 percent, the total combined capital gains tax rate exceeds the highest Massachusetts estate tax rate. However, when the donee receives assets upon the donor’s death, the donee receives a "stepped up" basis in the received asset equal to the fair market value of the assets as of the decedent's date of death. The donee can then sell the assets with a lower capital gains tax consequence.
The combined tax impact can be a trap for the unwary. If the capital gains tax impact is not fully examined, then a low basis gilt to save Massachusetts estate tax could result in a higher overall combined tax burden for the estate and the recipient of the gift. For example, a $1.5 million estate will generate a Massachusetts estate tax of $64,400. with no gifting, the donee of the estate can immediately sell the inherited asset with little to no capital gains tax consequence, because the donee received the asset with a stepped up basis. If instead the donor made a lifetime gift of an asset worth $500,000 with a $100,000 basis, the Massachusetts estate tax would l:e $33,200, resulting in estate tax savings of $31,200. However; if the donee then sold the asset, the capital gain would be $400,000, resulting in federal capital gains tax of $60,000 and Massachusetts capital gains tax of$20,800, for a total capital gains tax liability of $80,800. The total estate and capital gains tax consequence in this example is $114,000, ($49,600 greater than if no gift was made).
Lifetime gifting can be a simple, effective strategy to reduce Massachusetts estate tax for estates that are subject to Massachusetts estate tax and below the federal exemption. The total tax consequence should be analyzed before implementing lifetime gifting to ensure that unintended income tax consequences are not being created for the donee. Finally, the advisor must always stay informed of legislative updates to be sure that the strategy remains effective.
Ryan Swartz and Karen Witherell are a director and associate, respectively, in the Trusts and Estates Department in the firm's Woburn office.