Planning for The Millionaire’s Tax – Not Just for Massachusetts?
In November of 2022, the voters of Massachusetts approved a new 4% tax on state residents with annual income over $1 million. Combined with the state’s existing tax rate, it raises the top tax rate to 9% and applies to both ordinary income and capital gains. Now several state legislatures have introduced similar proposals including California, Connecticut, Hawaii, Illinois, Maryland, New York, Oregon, and Washington, totaling 60% of the nation’s wealth.
In Massachusetts, there were about 16,000 income tax returns filed with incomes over $1 million, or about 0.47% of all taxpayers who filed in 2020. My expectation is that most of those who routinely earn more than $1 million will have the resources to avoid the Massachusetts tax all together by moving out of Massachusetts. For those taxpayers whose income climbs over $1 million in a single year, such as when selling a business or a residence, this will not be a viable option. For those clients, there are several tactics to minimize the tax.
Spread out your income.
The Massachusetts law specifies that the additional tax is per tax return filed with income in excess of $1 million. Therefore, a married couple could spread out the income by filing separately, thereby having $1 million each of income, or $2 million total, that does not pay the additional tax. Taxpayers could file separately for Massachusetts and jointly for federal taxes as well.
Another way of spreading out your income is to spread out the payments over several years. This is especially useful when selling assets, such as when the taxpayer is selling a business or property. There are two ways to spread out the payments, one is to enter into an Installment Sale agreement, where the buyer pays the sale price over several years. The other is to transfer the assets to be sold into a charitable remainder trust which pays out the proceeds over a term of years, either a maximum of 20 years or for your lifetime. The result is that, if the payout is below the $1 million in any one year, the taxpayer avoids the tax.
Move out of Massachusetts.
Massachusetts taxes the worldwide income of individuals who are residents or are domiciled in the state. For non-residents not domiciled in Massachusetts, they are only taxed on income derived from a Massachusetts source. Going from being a resident domiciled in Massachusetts to a non-resident not domiciled in Massachusetts is both a subjective and objective process. Subjective as your domicile is where you consider your home to be. Objective because your must not spend 183 days or more in the state.
Trusts have always been a key element in estate planning – both revocable grantor trusts and irrevocable trust [i] For revocable grantor trusts, the rules on applicability of the tax are broadly the same as for an individual, since you include income paid to the trust on your individual income tax return. For an irrevocable trust, the income tax applies if the trust is a testamentary trust of an Massachusetts decedent or a trust created by a Massachusetts resident and there is at least one trustee who is a Massachusetts resident.
For existing trusts with multiple beneficiaries, the income could be spread out in a similar way to married couples filing separately, that is the trust forms a separate trust for each beneficiary and files a separate income tax return for each trust. Whether a trust can be so divided is complex and depends on the terms of the trust.
For new irrevocable trusts, a taxpayer can also avoid the tax by creating an irrevocable incomplete gift, non-grantor (ING) trust. So long as the ING trust does not have Massachusetts resident trustees, and the grantor has only limited rights over the principal and income of the trust, it will not be taxable in Massachusetts. By being an incomplete gift by the terms of control exercised by the grantor, the trust will not be considered a taxable gift for federal gift tax purposes. This is a technically complex tactic for tax avoidance and requires both an excellent draftsman and an excellent non-Massachusetts trustee.
So, the millionaire’s tax is already here for residents of Massachusetts and may soon be here for residents of California, Connecticut, Hawaii, Illinois, Maryland, New York, Oregon, and Washington and lost likely more. You face the choice of either paying the tax, leaving the state, spreading out your income, or do some complex trust planning. Which is best for each depends on their situation but know that you do have a choice to avoid the tax if you choose to do so.
[i] For a discussion of the different types of trust please see What is a Trust?