Because of the decoupling of the Massachusetts estate tax from the federal estate tax in response to the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), it has since 2002 been possible for the first time to reduce one’s overall estate tax burden by making gifts during lifetime that are subject to federal gift tax. While this technique has been available for six years now, it has not been as widely publicized among estate planning practitioners as it should have been. The purpose of this article is to publicize the technique and to explain why it works.
Perhaps the easiest way of introducing the technique is with an example. Take a hypothetical Massachusetts decedent, D, who dies in June of 2008 with a taxable estate of $2 million. Since the federal exemption amount for 2008 is $2 million, no federal estate tax will be due on D’s death. The Massachusetts exemption for 2008, however, is only $1 million, and so D’s estate will have to pay a Massachusetts estate tax. The Massachusetts estate tax will be levied on D’s adjusted taxable estate; the adjusted taxable estate is $1.94 million, and D’s estate will therefore pay a Massachusetts estate tax of $99,600.
If, on the other hand, D does not die owning the entire $2 million but instead gives away $1 million a month before her death, the tax result is different. This $1 million gift is an adjusted taxable gift, but since the amount of the gift is within the $1 million lifetime exemption from gift taxes under the Internal Revenue Code of 1986, as amended (the “Code”), § 2505, there is no gift tax due or payable. D’s federal taxable estate, moreover, is still $2 million, since for federal purposes, adjusted taxable gifts made during life are brought back into the estate for estate tax purposes. Of course, there is still no federal estate tax on this $2 million taxable estate. D’s Massachusetts taxable estate, however, is now only $1 million, since—and this is the key to the technique—adjusted taxable gifts are not brought back into the estate for Massachusetts estate tax purposes. The tax on a Massachusetts taxable estate of $1 million is $33,200. D has saved her estate $66,400 in taxes—not “chump change” by any stretch of the imagination—by making this taxable gift before her death. Note that the gift can be made up to the moment of death.
This, then, is why the technique works, in a nutshell. The important points to keep in mind are these:
• Code Section 2011 is still in effect for Massachusetts estate tax purposes;
• New Code Section 2058 is in effect for federal estate tax purposes;
• The federal estate tax is levied on the sum of the federal taxable estate and adjusted taxable gifts;
• The Massachusetts estate tax is levied on the adjusted taxable estate, period;
• The federal estate tax exemption amount for 2008 is $2 million;
• The federal gift tax exemption amount is $1 million;
• The Massachusetts estate tax exemption amount for 2008 is $1 million, but this is totally irrelevant to the tax calculation and is only relevant in determining whether or not a Massachusetts estate tax return must be filed. Again, the question of whether a return must be filed and the question of how much tax is due are independent questions except to the extent that if no return must be filed, no tax will be due. The converse is, however, not true, and sometimes—theoretically, at least—no tax will be due even though a return must be filed (in the case of, for example, a decedent who gives away $1 million and has nothing left after the gift).
Before EGTRRA, it was not possible to reduce overall estate taxes by making taxable gifts, because formerly we were under a sponge tax system. Under a sponge tax system, making taxable gifts reduces the Massachusetts estate tax for the same reason that I have just illustrated, but the overall tax burden remains unchanged, since a decedent’s estate simply receives less of a credit for paying the lower state death taxes. In other words, the total tax was the same but it was just allocated differently, with Massachusetts getting less and the feds getting more if taxable gifts had been made by the decedent during his or her lifetime. All of this has now changed.
It would seem at first blush, therefore, that people who have taxable estates between $1 million and $2 million could reduce their state and federal transfer taxes at death to zero simply by making a lifetime transfer in the amount of the difference between the value of their estate and $1 million. This is not, however, the case; complications arise because of the way the Massachusetts estate tax is calculated.
It is somewhat counterintuitive, but no unified credit, credit, or exemption was directly relevant to calculating the credit for state death taxes under Chapter 11 of the Code as in effect before EGTRRA was enacted. According to the tax table in 26 U.S.C. § 2011 (2000), that is, the first dollar of a decedent’s taxable estate is subject to state estate taxes under a sponge tax system. A taxable estate of $100 would, for example, without further restrictions, produce a Massachusetts estate tax of $0.80 under that tax table. The further restrictions here are crucial, and are provided by pre-EGTRRA Code § 2011(e), which limits the credit for state death taxes to the amount of the federal tax. This certainly makes sense: if the credit for state death taxes could exceed the federal estate tax, then taxpayers could claim refunds from the federal government on estate tax returns, when no tax had been paid to the federal government in the first place.
Again, there are three essential (and all obvious and interrelated) points to keep in mind here:
1) Under 26 U.S.C. § 2001(b) (2000), the estate tax is and was figured based upon “the sum of . . . the amount of the taxable estate and . . . the amount of the adjusted taxable gifts.”
2) Under 26 U.S.C. § 2011(b)(3) (2000), the credit for state death taxes was (before it was abolished) figured upon “the taxable estate reduced by $60,000.” That is, taxable gifts are completely irrelevant for the purposes of determining the credit for state death taxes.
3) The amount of the credit for state death taxes was, in most cases, therefore, completely independent of the amount of the unified credit and of the amount of adjusted taxable gifts.
In other words, to figure the total estate tax under a pure sponge tax regime, one computed the tentative estate tax on the sum of the taxable estate and the adjusted taxable gifts, then one subtracted from that tentative tax the unified credit amount. That gave one the total estate tax. Then one figured the amount of the state death tax credit, which gave one the amount to pay to the state and to subtract from the total estate tax for federal purposes.
So much for the obvious facts. Now for the obvious-but-not-obvious conclusion: the difference between what the amount exempt from federal tax because of the unified credit would have been under year 2000 law (i.e., $1 million) and what the federal exemption amount is today (i.e., $2 million) can totally escape Massachusetts taxation if given as a gift during the decedent’s lifetime. This is because Massachusetts never has had and (we hope) never will have a gift tax.
THIS CONCLUSION IS INDEPENDENT OF THE FILING THRESHOLD.
The now different filing thresholds for Massachusetts and federal estate taxes tend to muddy the waters here, because we tend to think about filing thresholds when we think about the differences between federal and state estate taxes and NOT about taxable gifts. These are almost entirely independent issues. Most of us are used to thinking of the exemption amount as directly relevant to the amount of estate tax due, because for federal estate tax, it is directly relevant. But in most instances, it is completely irrelevant to the amount of state estate tax due.
It is received wisdom that a tax credit is always better than a tax deduction, because a credit comes off the tax directly, whereas a deduction simply reduces the tax base. In general, therefore, a tax credit will always be preferable to a deduction. The present case is, however, one of the few where a deduction is in fact better than a credit, since if we were still under a sponge tax—i.e., tax credit—system, making taxable gifts could not reduce overall estate taxes, but under the current deduction system, it can. The following table shows the savings in Massachusetts estate tax that can be obtained by making a taxable gift of $1 million immediately prior to death:
Taxable Estate before Making Gift Massachusetts Estate Tax Savings
$1,500,000 $64,400
$2,000,000 $66,400
$2,500,000 $74,400
$3,000,000 $82,400
$3,500,000 $90,400
$4,000,000 $98,400
Of course, for large estates (over $2 million plus), making taxable gifts will reduce the Massachusetts estate tax and hence reduce the deduction under Code § 2058 (and thus increase the federal tax), but the federal increase will by definition not offset the Massachusetts decrease.
Note that one of the traditional tax reasons for making taxable gifts also still applies: all of the appreciation on the gifted assets between date of gift and date of death is removed from the taxable estate. This benefit may still be obtained. The other traditional tax reason for making taxable gifts is, however, less certain. In the past, it made more sense to pay some gift tax than to pay estate tax, because the gift tax is tax-exclusive whereas the estate tax is tax-inclusive. That is, in an estate, the tax is also taxed, but this is not true in the gift context. Due to the difference in the federal exclusion amounts for the estate and gift taxes, however, as well as to uncertainty about what the estate tax law will look like in coming years, taxable gifts that actually incur a gift tax are no longer as attractive.
Lest the reader come away with the impression that the technique presented here is controversial, risky, or purely theoretical, I conclude with a discussion of several of the Massachusetts Department of Revenue’s pronouncements on the subject. The Department of Revenue (DOR) has issued two publications that, both individually and taken together, can be read to suggest that taxable gifts must in fact be taken into account when figuring the Massachusetts estate tax: DOR Directive 03-2 and the Instructions for filling out Form M-706, Massachusetts Estate Tax Return. A close reading of these two publications reveals, however, that this is not the case. DOR Directive 03-2, “Issues Arising from Decoupling the Massachusetts Estate Tax from the Federal Estate Tax,” simply points out that for decedents dying on or after January 1, 2003, the filing thresholds are different for Massachusetts and federal estate tax purposes. This is, of course, true. This directive makes absolutely no mention of gift tax or of taxable gifts. As observed above, moreover, for the purposes of the Massachusetts estate tax, the filing threshold has no bearing on the amount of tax due. To see why this is the case, we need to look more closely at the DOR’s other pronouncement on the subject, which is contained in the Instructions for Filing Form M-706. At first glance, these instructions can be read to suggest that making taxable gifts will affect the amount of Massachusetts estate tax. The instructions read:
To determine whether a return must be filed for a decedent’s estate, add:
1. the adjusted taxable gifts (under section 2001(b)) made by the decedent after December 31, 1976;
2. the total specific exemption allowed under section 2521 (as in effect before its repeal by the Tax Reform Act of 1976) for gifts made by the decedent after September 8, 1976; and
3. the decedent’s gross estate valued at the date of death. (M-706 Instructions, page 1; emphasis in original)
The Instructions go on to state that “Adjusted taxable gifts affect the Massachusetts filing threshold but are not added to the taxable estate,” Id.
This is the key point. The problem is that it seems counterintuitive that making taxable gifts can affect one’s Massachusetts filing threshold but not the amount of tax due. To see how this can be the case, it is necessary to recall the procedure for filing a Massachusetts estate tax return for decedents dying in 2003 and later. Recall that the DOR now requires that a decedent’s estate, if it is large enough to be taxable, file not one, but at least two and in many cases three estate tax returns with the DOR, as follows: A decedent with an estate that is taxable for Massachusetts purposes—i.e., over the Massachusetts filing threshold of $1,000,000—must file not only Form M-706 but also the now outdated federal Form 706 that was in use in the year 2000. Estates must file this form because the Massachusetts estate tax is currently set equal to the credit for state death taxes as it would have been under federal law as it existed in the year 2000, and to figure out what this credit would have been, one must fill out and file with the DOR the federal estate tax return that was in use in the year 2000—using, however, not the year 2000 unified credit, but the unified credit as it would have been for the year of death under year 2000 law. It is this phantom federal return—“phantom” because it is only filled out for Massachusetts purposes and of course never filed with the federal government—that determines the Massachusetts filing threshold, according to the DOR.
If we look at the phantom federal return itself—i.e., the July 1999 revision of federal Form 706—everything should become clear. The directly relevant lines of this form are lines 3,-6, 13, and 15.
Line 3 is the taxable estate (gross estate minus allowable deductions).
Line 4 is the adjusted taxable gifts.
Line 5 is the sum of lines 3 and 4.
Line 6 is the tentative tax on the amount in line 5.
Line 13 is the allowable unified credit.
Line 15 is the credit for state death taxes. One is instructed to “figure the credit by using the amount on line 3 less $60,000.” This credit for state death taxes on the phantom federal form gives one, of course, the amount of the Massachusetts estate tax itself.
Finally, an example of how the phantom federal return would actually be filled out is in order. For example, a decedent who had a $900,000 taxable estate and had made gifts of $600,000 during lifetime would have the following (for death in 2008) filled in on the phantom federal return:
Line 3 $900,000
Line 4 $600,000
Line 5 $1,500,000
Line 6 $555,800
Line 13 $345,800
Line 15 $27,600
Note that line 5 is the sum of adjusted taxable gifts and the taxable estate, and since line 5 is over $1 million, a Massachusetts estate tax return must be filed, even though the Massachusetts taxable estate (line 3) is under the exemption amount. Moreover, even though the Massachusetts taxable estate is under the exemption amount, there is still a Massachusetts estate tax due (hence my earlier remark that the exemption amount has no bearing on the amount of tax due). The credit for state death taxes under year 2000 law would have been $27,600, which is less than the federal tax that would have been due in 2000 (i.e., $210,000, obtained by subtracting line 13 from line 6 above), and so the Massachusetts estate tax is equal to the credit for state death taxes under year 2000 law, or $27,600.
If on the other hand the same decedent had made no taxable gifts, the phantom federal return would have the following:
Line 3 $1,500,000
Line 4 $0
Line 5 $1,500,000
Line 6 $555,800
Line 13 $345,800
Line 15 $64,400
There is no 2008 federal tax due in either case because the taxable estate plus adjusted taxable gifts (line 5) is under $2,000,000. Line 15 on the phantom federal form, credit for state death taxes, again gives the Massachusetts estate tax, and here we see that by making gifts that were taxable gifts (but not taxed) for federal purposes, the decedent has saved $36,800 in Massachusetts estate taxes.