Edwards Wildman Palmer LLP

New Massachusetts Estate Tax Law

March 12, 2003

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Over the past number of months, in an attempt to increase revenue in the face of a difficult budget environment, the Massachusetts legislature has passed substantial changes to the Massachusetts estate tax. In fact, the changes to the structure of the tax are so significant that it may be best to characterize the legislature's action as the enactment of an entirely new tax.

To understand the new tax, some background information is necessary. Since 1997, the Massachusetts estate tax has been what is commonly referred to as a "sponge tax". By enacting a sponge tax, Massachusetts effectively adopted a revenue-sharing arrangement with the federal government under which Massachusetts would collect an estate tax equal to the maximum credit for state estate taxes that could be claimed on a federal estate tax return. With such a tax, the federal government essentially would "share" with Massachusetts a portion of the federal estate tax, and Massachusetts would not levy a tax in excess of that portion.

As part of the 2001 federal tax legislation, Congress adopted a slow phase-out of the federal estate tax which takes effect over the next several years. The federal estate tax then is repealed in its entirety on January 1, 2010 and, under the now-infamous "sunset provision", returns to its pre-2002 form beginning January 1, 2011.

Although the federal estate tax is phased out over a ten-year period, the credit for state death taxes - the basis for the Massachusetts estate tax - is phased out more rapidly. Therefore, this year the federal government shares with Massachusetts only 50% of the revenue that previously would have been available. In 2004 the state portion is reduced to 25%. In 2005 the credit for state death taxes is eliminated completely, at which time the payment of state estate taxes will qualify for a deduction (generally much less valuable to taxpayers than a credit) on the federal estate tax return.

In response to potential loss of revenue from these tax phase-outs, new Massachusetts legislation dictates that, for estates of decedents dying on or after January 1, 2003, the Massachusetts estate tax will be computed based on the federal law that was in effect on December 31, 2000.

Because there were a number of uncertainties with respect to the operation of the tax, on February 19, 2003, the Massachusetts Department of Revenue issued important guidance on the new tax in the form of a "Directive". That ruling, Directive 03-2, confirms many operating assumptions about how the tax will be computed, and what planning can be done to minimize the effects of the tax.

At this time, there are a few points that clients should keep in mind:

• The new tax presents particular estate planning challenges for married taxpayers. Traditional estate planning techniques intended to defer taxes until the death of the second spouse while taking full advantage of the federal estate tax credit protected amount may cause some Massachusetts tax to become due at the death of the first spouse. Directive 03-2 makes clear that this result can be avoided with careful planning.

• As a result of the new legislation, the threshold for filing an estate tax return and for paying tax is lower for Massachusetts purposes than it is for federal purposes.

• For all estates subject to Massachusetts estate taxes, this legislation represents a potentially significant increase in aggregate estate taxes. There are, however, planning techniques available that can reduce or eliminate the tax.

• Although those living outside of Massachusetts are not subject to the Massachusetts estate tax on their entire estates, any individual who owns real estate or tangible property in Massachusetts and whose estate exceeds the filing threshold in the year of death will be required to file a Massachusetts estate tax return and, potentially, pay Massachusetts tax. Again, careful planning may help avoid the new tax entirely.

The following table shows, for each year through 2009, (i) the federal unified credit; (ii) the Massachusetts filing threshold; and (iii) the potential Massachusetts estate tax exposure for married taxpayers whose plans do not accommodate Massachusetts tax deferral, and for single taxpayers with estates equal to the federal credit amount:

It is likely that many estate plans drafted over the past several years do not accommodate Massachusetts estate tax deferral. Clients should have their estate plans reviewed to determine whether changes need to be made to address the new Massachusetts estate tax.