Section Review

Back from the Dead: The New Massachusetts Estate Tax

Mark WilliamsonMark W. Williamson is a partner in the Boston law firm of Casner & Edwards and chairman of the Probate Law Section.

Back in 2001, the administration in Washington passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), a part of which purported to temporarily repeal the estate tax, effective in 2010. Between now and then, the applicable exclusion amount (which is the amount that an estate may pass to non-spousal beneficiaries without taxation) will ramp up from today's $1 million to $1.5 million in 2004 and 2005, followed by $2 million in 2006 through 2008, up to a maximum of $3.5 million in 2009. In 2010, the little-loved tax will be repealed for a year and replaced by a complex and arguably unworkable system based on carry-over basis (rather closer to the system in that bastion of low-tax, free-market capitalism, Canada), only to be reinstated with a mere $1 million exclusion in 2011.

The federal estate tax has long allowed a credit against state estate taxes, so as to minimize (although not always eliminate) double taxation of the estate. Many states adopted a system under which they would limit the imposition of their state tax to the amount allowed as a credit under the federal system. In 1997, partly to stem the tide of tax-refugees to states such as Florida and Arizona, Massachusetts abandoned its confiscatory, independent estate tax system, and replaced it with a so-called "sponge tax." This meant that Massachusetts would no longer assess an estate tax in accordance with its own quirky rules, but rather would "piggyback" onto the federal tax system, taking only such amounts as the federal tax would allow. Thus, the estate would pay only the amount that would otherwise be due to the IRS, and the federally taxing authorities would allow an appropriate portion of that payment to be allocated to the state.

With the implementation of EGTRRA, as the federal estate tax repeal gradually took effect, there would be a predictable, negative impact on federal estate tax revenues. Congress, faced with stanching the loss, began to view the state death tax credit as representing a fund source that the federal authorities could no longer afford to sacrifice. Consequently, EGTRRA provides for a phase out of the state death-tax credit, replacing it with a mere tax deduction for state estate taxes. This change is slated to be fully implemented by 2005.

Of course, a tax deduction is far less costly to the government than a tax credit - only about half as expensive. Unfortunately, the change between a credit (which amount could then be scooped up by the state), and a deduction (which avoids double-taxation, but doesn't directly benefit the state) would have a deleterious effect on Massachusetts tax collections, and the timing just couldn't be worse. Just as the economic downturn decimated state collections of capital gains, sales and employment taxes, this lucrative fund source would disappear as well. Clearly, a remedy was needed to replace the lost revenue.

The state "fix" has been to reinstate an independent Massachusetts estate tax. Found at Mass. G.L. ch.65C section 2(A)(a), the new law provides that the commonwealth would impose a tax on estates equaling the credit for state death taxes that would have been allowable to a decedent's estate as computed under the laws federal law in affect on Dec. 31, 2001.

The federal law in question provided a more modest relief from the federal estate tax than the temporary repeal afforded by EGTRRA. For example, in 2003, estates under the old law would be subject to tax to the extent that they exceeded $700,000 in value (the current EGTRRA rules exclude estates under $1 million in 2003). This means, in 2003 and thereafter until 2011, there will be an actual, independent Massachusetts estate tax liability for estates in excess of the Massachusetts exemption amount (under the current law, in 2011 the Massachusetts exclusion, which will stall at $1 million, is brought back into line with the federal exclusion, which will fall precipitously back to $1 million from complete repeal the prior year).

Over the next few years, the following size estates will be excluded from tax:
Year MA Excl. Federal Excl. MA Exposure If Federal Excl. Passes to Non-Spousal Beneficiary Actual MA Tax
2003 $700,000 $1,000,000 $300,000 $32,200
2004 $850,000 $1,500,000 $750,000 $64,400
2005 $950,000 $1,500,000 $650,000 $64,400
2006 $1,000,000 $2,000,000 $1,000,000 $96,600
2007 $1,000,000 $2,000,000 $1,000,000 $96,600
2008 $1,000,000 $2,000,000 $1,000,000 $96,600
2009 $1,000,000 $3,500,000 $2,500,000 $229,200
2010 $1,000,000 N/A Sky's the limit! Unlimited!
2011 $1,000,000 $1,000,000 $0 $0

How does the estate-planning attorney deal with the discrepancy between the Massachusetts exclusion and the federal exclusion? A technique from the past will work: involving the utilization of the marital deduction.

Under federal law, there is no estate tax on transfers to one's surviving spouse (who is a U.S. citizen), provided that certain criteria are met. Thus, a gift outright to the surviving spouse will be free from estate tax, both for federal and Massachusetts estate tax purposes. However, if one leaves the exemption amount to the surviving spouse outright, the amount is taxed in the survivor's estate, thus eliminating the benefit of the first spouse's exemption (to the extent that the survivor hasn't consumed the funds during the survivorship period). For this reason, an outright gift to the spouse is often not desirable, as it limits the utilization of the first spouse's lifetime exemption (currently $1 million), which could otherwise pass to the next generation free from taxes. Typically, we would desire to hold at least that exemption amount in trust, such that it would not be subject to tax both on the first death and on the survivor's death.

The IRS begrudgingly allows a free transfer to the surviving spouse for two basic reasons: it is too difficult to keep track of interspousal transfers, and thus most would be unreported (thus creating an atmosphere of casual noncompliance, which could spill over onto other areas of tax collection); and it is bad public relations to sock a grieving widow or widower with an estate tax upon the first death. Nonetheless, the IRS doesn't want to increase this freebee by allowing tax-free gifts to someone other than the surviving spouse, so the IRS does not allow a deduction unless the gift is more or less fully dedicated to the survivor during the survivor's overlife.

The legislature did recognize, however, that in certain situations it was appropriate to allow the marital deduction for a transfer that was less than absolutely outright to the surviving spouse. For example, if the surviving spouse is a second spouse (i.e. a subsequent spouse after the death or divorce of the first), the surviving spouse may not be the parent of the first decedent spouse's children. The first decedent might be perfectly willing to provide for the surviving spouse for the survivor's lifetime, but still desire that the children of the first decedent benefit from the estate after the survivor's death. In this way, a subsequent marriage of the surviving spouse (and, perhaps, subsequent children of such marriage) would not divest the first decedent's children of their parent's legacy.

To address such situations, the legislature created Qualified Terminable Interest Property - commonly referred to by its acronym QTIP. One can create a trust with QTIP provisions (basically, that all of the income is paid to the surviving spouse on a current basis, and that no distributions of principal be allowed to anyone other than the surviving spouse during the survivor's overlife, and the survivor can't have full control over the disposition of the assets that are left over upon the survivor's death). If a trust fulfills the QTIP requirements and the executor or trustee makes the proper election, a marital deduction can be taken. If a marital deduction is taken, then the assets, to the extent that they are not consumed during the survivor's overlife, will be taxed as part of the estate of the surviving spouse. If (or to the extent) no marital deduction is taken, then the assets are taxed to the estate of the first spouse, and the remainder of the assets in the trust upon the death of the surviving spouse escapes taxation on the surviving spouse's death.

As was the case in earlier years, before the advent of the "sponge tax," the DOR has indicated that it will once again allow inconsistent QTIP elections for federal and Massachusetts purposes. This means that a trust fulfilling the QTIP requirements can be treated as marital property for Massachusetts purposes (and thus free from tax in the first estate), and as non-marital property passing under the lifetime exemption for federal purposes (and thus free from federal taxation in both the first estate and the second.)

This year, for example, the federal tax lifetime exclusion is $1 million, whereas the Massachusetts exemption is only $700,000. A QTIP trust may be created and funded with the maximum federal exclusion - i.e. $1 million. For federal purposes, no QTIP election would be made, and thus the assets in the trust, although held for the surviving spouse throughout his or her lifetime, would not be taxable in the survivor's estate.

For Massachusetts purposes, however, a QTIP election would be taken for the excess of the federal exemption amount over the Massachusetts exemption amount, or $300,000. This $300,000 would not be taxed on the death of the first spouse, but to the extent that it was not consumed during the survivor's overlife, it will be taxed to the survivor's estate. A carefully drafted trust would provide that, to the extent distributions of principal must be made from the family trust to the survivor, such distributions should be made from the part of the family trust for which the Massachusetts QTIP election was made. In that way, the part of the family trust that would be subject to Massachusetts taxation upon the death of the survivor would be consumed first, and thus not available to be taxed on the second death.

Of course, making principal distributions to the surviving spouse is best done from the portion of the trust, if any, that would be subject to both federal and Massachusetts estate tax upon the death of the survivor - i.e. the marital trust - but if there are no marital trust assets available and distributions become necessary from the family trust, then that part which will be includible for Massachusetts purposes is the obvious source.

Instruments also could be drafted to provide that funds in the amount of the difference between the federal and state exemptions upon the date of death pass outright to the surviving spouse, or are diverted into a marital trust for the survivor's benefit. This can be done by the executor or the trustee. The problem with this approach is that any such assets will be included in the estate of the surviving spouse, to the extent not consumed by the survivor.

Wills also can be drafted to allow the first spouse to pass the entire estate to the survivor. Then, to the extent the surviving spouse wished to take advantage of the federal and state exemptions, he or she could disclaimer the outright bequest, which then could be made to pass into a QTIP-ready family trust, wherein QTIP treatment could be elected for federal and/or Massachusetts purposes, as the case may be.

One could also draft a three-part trust, in which the federal exclusion amount would pass to the a family trust for the benefit of the surviving spouse and/or issue, a QTIP Massachusetts marital trust for the excess of the federal exemption amount over the Massachusetts exemption and a marital general power of appointment trust for the remainder of the estate.

The bottom line, however, is that the disparity between the federal and Massachusetts estate tax regimes is likely to disappear by 2011, but no one knows for sure what the future holds. It is important to draft for the greatest flexibility, and keep a keen eye on the developing law.

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