Written by: Deborah Cartisser
Last November, voters approved new legislation to change the state’s constitution to impose a 4% surtax on income that exceeds $1 million, in addition to the 5% flat income tax. The law went into effect on January 1 of this year. Governor Maura Healey expects the new tax to generate $1 billion in additional revenue this year, which is earmarked for public education and transportation. Learn about the ways this tax could affect you.
The millionaire tax legislation had additional features that some voters may not have been aware of. The tax is imposed on earned income, such as salary that appears on a W2, but it also includes windfalls like the sale of property and businesses. Perhaps you are a modest earner, who goes to sell investment property that has appreciated significantly. Your earned income, combined with the capital gains proceeds from your property, may put you over the threshold and subject you to this new tax. When selling your primary residence, you are entitled to exclude up to $250,000 of capital gains ($500,000 if filing jointly) from taxes. However, this exclusion is not available for rental or investment properties. Similarly, selling a business built over many years may also put you temporarily into the high earner category, if the capital gain is enough to put you over the $1 million threshold when added to your other earnings. The additional tax may also affect workers who receive a windfall from the company stock they own, or additional equity compensation.
While this tax may fill the needy coffers of the state, and be put towards good causes such as school lunches or infrastructure repair, you may have some options to consider to reduce your tax burden. First and foremost, consult your tax and financial advisor BEFORE your financial event takes place. With some advanced planning, you may be able to reduce some of the impact of the tax. If the windfall event takes place and you consult with your financial/tax advisor afterward, many of the tax saving strategies may no longer be available to you. So let me say that again: consult with your financial/tax advisor BEFORE the liquidity event takes place. Don’t negotiate your business sale and then go to your advisor to discuss strategies. The door may have closed on any options you would have had. What can you do to mitigate some of the tax?
Change Filing Status
Massachusetts has a unique strategy that allows married taxpayers to file separately in any given year. Each individual is entitled to claim $1 million in income/capital gains without being subject to the millionaire’s tax. By filing separately, you can each claim $1 million in earnings before being subject to the additional tax. Ask your tax professional to model this for you to quantify any disadvantages due to filing separately. While this loophole may be closed in future legislation, it is available at the time of this writing.
Installment Sales
When selling a business or investment property, consider an installment sale, which can spread the income out over multiple years, rather than recognizing it all in one year.
Charitable Gifting
Another option to consider is grouping all your future charitable contributions together and funding a large contribution to a Donor Advised Fund. This will allow you to match the large charitable contribution in a high-income year to offset some of the tax. The donor advised fund contribution allows you to recognize the charitable contribution in one year and make charitable grants in subsequent years, with no further tax offset.
1031 Property Exchanges
For those selling rental or other investment property, the federal and state capital gains taxes can be postponed, through the exchange to other income producing property by utilizing a 1031 exchange. The tax is not avoided, it’s postponed until the replacement property is sold. You need to close on the replacement property within 180 days from the close of the original sale. This can be an effective tool for someone who wants to sell but doesn’t want the capital gain to be realized until a future date. If the property is held until the owner’s death, the cost basis would be stepped up and the tax avoided.
Family Limited Partnership (FLP)
In this strategy, the business owner transfers his company ownership into an FLP entity. The business owner is able to maintain control over the business while gradually transferring ownership to other family members. By gifting limited partnership interests, the owner can reduce their taxable impact and shift income and ownership to lower bracket taxpayers and spread the tax burden from one to multiple owners. This can be a compelling way to transfer a closely held business to multiple generations.
Fund Irrevocable Trusts
Prior to selling any property, a high-income resident may opt for creating an irrevocable trust to move an appreciating asset out of their estate. There are different types of trusts which can be used for this purpose, some of which can be drafted to be domiciled in other states. This can be an effective strategy to transfer property that you expect to appreciate significantly when you can afford to transfer it irrevocably.
Change Domicile or Move
Due to increased taxes, transportation, and childcare options, Massachusetts is seeing an exodus of residents leaving the state permanently, seeking refuge in states with lower income taxes and lower costs of living. Many are fleeing to states without income taxes. Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming do not have earned income taxes. New Hampshire doesn’t tax earned income but does tax income and capital gains. For those considering moving out of the state, look closely at what other taxes are imposed, such as high property taxes, and consider the cost-of-living comparison. For example, Alaska has the lowest overall tax burden, but the cost of living is among the highest in the country.
Our advice – start the conversation with your tax or financial professional well in advance of your windfall event. There is no single perfect planning solution that works for everyone, so advanced tax and estate planning requires customized solutions. If you don’t currently have an advisor, consult with your estate planning attorney or tax advisor to see who they recommend. Involve your advisors before any considerations of sale. Once the liquidity event has taken place, your options for tax-reducing strategies have dwindled significantly. Discuss your options with Twelve Points to determine if there is a tax-saving strategy that’s right for your situation.
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