Proposed Change to Massachusetts Basis Rules to Address 2010 Changes in Federal Estate Tax Laws

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Kenneth P. Brier, Esq., Brier & Geurden LLP
Andrew D. Rothstein, Esq., Goulston & Storrs, P.C.

As things stand now, there is some concern that as a result of the change in federal basis rules for 2010, and no corresponding Massachusetts change, a substantial, hidden Massachusetts tax problem has arisen for successors to decedents’ property.

When the federal government decided to reduce and repeal the federal estate tax beginning in 2002, it planned to offset some expected revenue loss by (i) eliminating the portion of the estate tax revenue it effectively shared with the states via the state death tax credit and (ii) eliminating in 2010 the so-called “step-up” in basis, which established date-of-death (or 6-month alternate) valuations for all inherited property.

Under this plan the estate of a 2010 decedent would pay no federal estate tax, but the decedent’s heirs would be responsible for paying income tax on pre-death capital gains on inherited appreciated property when they sell it. To some, this seemed like an acceptable tradeoff – capital gains taxes on pre-death gains in lieu of much higher estate taxes.

In response to the changes to the federal estate tax system, effective for decedents dying after December 31, 2002 Massachusetts enacted its own estate tax. The Department of Revenue indicated that the tax was enacted in order to preserve the revenue the Commonwealth received before the 2002 federal estate tax changes. However, at that time Massachusetts did not make any changes to its rules relative to the basis of property inherited from a decedent. As a result, it appears that decedents dying in Massachusetts in 2010 will be subject to Massachusetts estate tax on their assets and the decedent’s heirs will be responsible for paying income tax on pre-death capital gains on the inherited appreciated property when they sell it.

In effect, under the current Massachusetts tax rules assets that historically were subject to only one level of tax will now be subject to two levels of tax.

Consider, for example, the impact of inheriting a Beacon Hill row house valued at $10 million at the decedent’s date of death but purchased for a tenth of that amount in the 1960s. Under the rules that existed last year, the heirs would have paid roughly $1,067,600 of Massachusetts estate tax and inherited the house with a basis equal to the date-of-death (or alternate) value, so if they sold it for its date of death value the day after the decedent died, there would be no Massachusetts capital gains tax. Under the rules that exist in 2010, the heirs would still pay roughly $1,067,600 of Massachusetts estate tax and inherit the house with a basis equal to what the decedent paid for it in the 1960s, so that if the heirs sell the property for its date of death value the day after the decedent dies, there would be a 5.3% Massachusetts capital gains tax on $9,000,000 of gain resulting in $477,000 of extra tax.

The concerns laid out above are based on a technical, but we think inescapable, reading of the applicable tax statutes.

Massachusetts has its own tax basis rules set forth in chapter 62, §6F. These rules interrelate heavily with the federal basis rules, but are independent of them. Section 6F(b)(2)(C) generally applies IRC §1014(b) (step-up in basis at death) to property acquired from a decedent. The reference to section 1014(b) of the Code, however, must be read in conjunction with the definition for “Code” for purposes of chapter 62, as set forth in §1(c). With exceptions for certain Code sections not relevant here, that definition provides that “Code” means the Internal Revenue Code of the United States, as amended on January 1, 2005 and in effect for the taxable year. “Code” therefore would include IRC §1014(f), enacted in 2001 under EGTRRA, which provides that §1014 shall not apply to decedents dying after December 31, 2009. So there is no longer any general Massachusetts basis step-up (or step-down) for property acquired from decedents.

In the absence of any general basis step-up, it seems that a successor’s initial Massachusetts basis would be determined under §6F(b)(2)(B), related to property whose federal basis is determined in whole or in part by application of the basis of prior property. That provision provides that the Massachusetts initial basis shall be the initial federal basis of the acquired property (or its Massachusetts basis, if different), if there was no federal gain or loss with respect to the transaction (presumably the transaction by which the property was acquired). Under §6F(c), Massachusetts initial basis is thereafter adjusted by applying the same adjustments as are made to the federal basis after the initial basis as determined, with certain exceptions. Among the exceptions, pointedly, “[t]here shall be disregarded any federal adjustment resulting from provisions of the Code that were not applicable in determining Massachusetts gross income at the time such federal adjustments were made….” Since the allocation of additional basis under IRC §1022 (applicable for 2010) is not an item in determining Massachusetts gross income, it does not seem that it can be a basis adjustment for Massachusetts tax purposes. In the absence of a legislative fix, it seems that all Massachusetts property acquired from decedents will be acquired with a carryover basis, without any further adjustment.

The lack of any Massachusetts basis step-up would create serious complications for any taxpayer acquiring property from a decedent this year or thereafter. . Without any basis step-up, Massachusetts basis would be lower than federal, and Massachusetts gains would be commensurately higher. Moreover, this disconnect creates a serious trap for so-called pourover trusts containing a “pecuniary” subtrust funding formula. Such a funding formula, though offering several advantages, has always imposed the potential of triggering of the recognition of gain upon funding. That problem has typically been manageable to the extent persons administering the trust are dealing only with post-mortem gains. It is a lot more serious to deal with gains accrued over the decedent’s lifetime and not reduced by the federal allocation of increased basis.

Our proposal is simply to maintain the section 1014 basis step-up rules this year and thereafter. Those rules have commonly been thought of as “fair play” in mitigating the potential for double taxation in the face of an estate tax. Given the Commonwealth’s continuation of its estate tax in the face of the apparently temporary federal repeal, a continuation of the basis step-up rules can be viewed as both consistent and fair. Our proposal is to state explicitly that IRC §1014(f) is not to be given any effect for Massachusetts purposes, thereby reading IRC §1014 back into the law. Consistent with that approach, the proposal also confirms that the federal $1.3/3 million additional basis allocations under IRC §1022(b) and (c) are not to apply for Massachusetts purposes.

One could conceive of an alternative whereby Massachusetts simply conforms its determination of basis in property acquired from decedents to the federal basis this year and thereafter. This approach would provide the benefit of avoiding the need, both for taxpayers and the DOR, to track divergent federal and state tax basis. However, we think that such divergent bases will be relatively uncommon, except for wealthier decedents for whom the $1.3/3 million additional federal basis step-up might not be sufficient to raise their bases to date-of-death fair market values, and we think that the estates of such wealthier decedents are the ones which commonly will be equipped to track separate federal and Massachusetts bases. We think that fairness considerations therefore should prevail over these limited concerns about added administrative burdens.