By Heidi A. Seely and Matthew J. Leonard.
Gifts can reduce taxes, but maybe not in the way you think.
With the 2017 Tax Cuts and Jobs Act passed and effective as of January 1, 2018, the amount each individual can transfer during life or at death without incurring any Federal estate or gift tax has increased to $11.4 million per person for 2019. This exemption could continue to increase, pursuant to inflation, each year until 2026 (when the law is scheduled to “sunset” and revert back to an exemption of $5 million, indexed for inflation). While it is impossible to predict how Congress will act in the future, currently, Federal estate and gift taxes will increasingly only be applicable to a very small portion of the population. As a result, many of our clients are turning their thoughts to how to avoid or reduce their state level estate tax.
In Massachusetts, an estate tax is generally applied to estates which exceed $1 million, based on a progressive rate scale, with rates starting at .08% and increasing to 16%. Massachusetts has no state-level gift tax, meaning a Massachusetts resident can give away unlimited assets without incurring Massachusetts gift tax. Unfortunately, we have found that too often, clients and financial planners believe that using gifts to reduce the client’s estate below $1M will also completely avoid Massachusetts estate tax. While gifts can ultimately reduce the Massachusetts estate tax paid by a decedent’s estate, the question of whether an individual can eliminate the need to file an estate tax return or pay Massachusetts estate tax by making lifetime gifts is a bit more complex.
Calculating the Massachusetts estate tax is a two-step process; 1) a personal representative must determine whether an estate tax return (Form M-706) must be filed, i.e. whether the estate is greater than the “Filing Threshold”, and 2) then the personal representative will determine what, if any, estate tax owed to Massachusetts.
The Filing Threshold
If an estate exceeds, $1 million, the “Filing Threshold”, the personal representative must file a Form M-706 with the Massachusetts Department of Revenue. The Filing Threshold is determined by adding:
1) Any adjusted taxable gifts made by the decedent after December 31, 1976 (plus a specialized credit if gifts were made between September and December, 1976); and
2) The decedent’s gross estate valued as of date of death.
If the sum of those two values exceeds $1 million, the personal representative must file a Form M-706 for the estate. Once the Filing Threshold is surpassed, the entire gross estate is subject to tax based on a progressive rate table with tax rates ranging from .08% to 16%, even if the estate itself is less than $1 million.
It is relatively easy to determine the value of the decedent’s gross estate – any asset over which the decedent had material control is valued as of date of death and included in the calculation. The second part of the threshold, or what constitutes a “taxable gift”, deserves a bit more attention. Although Massachusetts does not have its own gift tax, the Commonwealth looks to the Federal gift tax rules in order to identify what constitutes a “taxable gift”.
Under the 2019 Federal gift tax regime, an individual can may make gifts up to $15,000 per year to as many people as he or she wants without paying any gift tax or filing a Federal gift tax return. This $15,000 limit is known as the annual exclusion. Any gift over the annual exclusion is a “taxable gift”. The person making the taxable gift (also known as the “donor”) is required to file a Federal gift tax return and will potentially pay a gift tax. Taxable gifts are first “charged against” the donor’s $11.4 million of Federal estate/gift exemption. For example:
Diana, the donor, has never made any large gifts. In 2019 she decides to give a gift of $415,000 to her daughter. The first $15,000 of the gift qualifies as an annual exclusion gift, and does not incur any gift tax or use any of Diana’s estate/gift exemption. The remaining $400,000 is a taxable gift and therefore, the entire gift must be reported on a federal gift tax return. No gift tax will be due, however. Instead, the $400,000 taxable gift is covered by Diana’s estate/gift exemption, which is thus reduced to $11 million. Diana can use her remaining $11 million exemption to shield future lifetime gifts or transfers at her death from estate/gift tax.
Interrelation Between Gifts And Estate Tax
Even when the gross estate is less than $1 million, a Massachusetts estate tax may still be owed if enough taxable gifts were made during lifetime so that the sum of the gross estate and the taxable gifts exceed the Filing Threshold. This peculiarity of the Massachusetts system can often lead to confused and angry family members when the news is broken that they will be sending the Commonwealth a check even after the decedent made large lifetime gifts to get their gross estate under $1 million.
Some examples may help (Julie and Susie are Massachusetts residents):
1) Julie made no gifts during her lifetime and passed away with a gross estate of $1.6 million. Her personal representative will need to file a Form M-706 and the estate will owe an estate tax of $70,800.
If Julie had made $300,000 worth of taxable gifts to her son, Paul, during her lifetime and filed the requisite federal gift tax returns and passed away with a gross estate of $1.3M. Her personal representative will need to file a Form M-706 and the estate will owe an estate tax of $51,600.
If Julie had instead made $800,000 worth of taxable gifts to Paul during her lifetime, filed the requisite federal gift tax returns and passed away with a gross estate of $800,000. Since the combination of taxable gifts and gross estate still exceeds the Filing Threshold, Julie’s personal representative will need to file a Form M-706 and the estate will owe an estate tax of $22,800.
2) Susie made no gifts during her lifetime and passed away with a gross estate of $10.5 million. Her personal representative will need to file a Form M-706 and the estate will owe an estate tax of $1,146,800.
If Susie had made $8M worth of taxable gifts to her niece, Paula, during her lifetime and filed the requisite federal gift tax returns and passed away with a gross estate of $2.5M. Susie’s personal representative will need to file a Form M-706 and the estate will owe an estate tax of $138,800.
If Susie had instead made $10.2 million worth of taxable gifts to Paula during her lifetime, filed the requisite federal gift tax returns and passed away with a gross estate of $300,000. Since the combination of taxable gifts and gross estate still exceeds the Filing Threshold, Julie’s personal representative will need to file a Form M-706 and the estate will owe an estate tax of $3,600.
As you can see from the two examples, the greater the value of gifts made, the greater the overall estate tax savings. This result stems from the fact that the Massachusetts estate tax is calculated only on the gross estate itself, rather than the combined value of the gross estate and taxable gifts. Reducing the gross estate through gifts will result in a lower estate tax, even if making gifts won’t completely eliminate the Massachusetts estate tax.
The relationship between the Massachusetts estate tax and the Federal gift tax regimes can lead to somewhat surprising results. We often still encourage our clients to make gifts if they would like to – not only for the estate tax benefit, but also for the pleasure they gain through their generosity. It is important to think through any gift to understand the full impact (loss of control, estate tax, future income tax, etc.) of a particular gift, to make sure the donor’s intent is met without unintended consequences. If you have questions regarding how gifts will affect your estate planning, please do not hesitate to contact any one of our Trusts & Estates attorneys.
Heidi A. Seely is an associate and Matthew J. Leonard is a director both with law firm Rackemann, Sawyer and Brewster.