Handling State-Level Taxation: Lessons from Two States

Two new state taxes that have recently been enacted are causing quite a stir: Massachusetts’ “millionaire’s tax” and Washington’s capital gains tax. Can they shed light on how taxpayers might navigate the evolving state-tax landscape?

Massachusetts

In November 2022, Massachusetts voters approved a ballot measure amending the state’s 5% flat income tax. The amendment includes a 4% surtax on a resident’s ordinary income and long-term capital gains that exceed an inflation-adjusted $1 million threshold.<sup>1</sup> This new tax affects both high-income earners and individuals who experience a one-time realization event, such as the sale of a home or a company.

Washington

Enacted in 2021, Washington’s 7% tax on certain long-term capital gains was challenged on grounds that the state’s constitution prohibits an income tax rate of more than 1% and requires uniform application among taxpayers. However, in March 2023, the Washington Supreme Court classified the tax as an excise tax—not an income tax—allowing the state to begin enforcing it.<sup>2</sup>

The tax only applies to long-term capital gains allocated to Washington and recognized (directly or indirectly) by individual taxpayers, subject to a $250,000 annual deduction and other limited deductions, credits, and exemptions. Importantly, a Washington resident is considered the owner of a proportionate share of any long-term capital assets held through a pass-through entity or other entity disregarded for federal income tax purposes.<sup>3</sup> This attribution includes assets contributed to a grantor trust, which are treated as owned by the trust’s creator for income tax purposes. The tax also applies to long-term capital gains within a nongrantor trust created by a Washington resident (i.e., a trust treated as a separate taxpayer for income tax purposes) if the trust is designed to avoid a taxable gift at funding.<sup>4</sup>

Although the Massachusetts and Washington taxes differ in their application and scope, taxpayers in either state can use the following planning strategies to reduce the impact of the tax.

Mitigation Strategies

Since both taxes depend on the residency of the taxpayer and their assets, the simplest strategy may be to relocate. Moving would allow non-residents of Massachusetts<sup>5</sup> to avoid the surtax on all non-Massachusetts taxable income, while non-residents of Washington<sup>6</sup> can avoid that state’s capital gains tax altogether.

But relocating can be a hassle, and some taxpayers may prefer to remain where they are. In such cases, gifting appreciated assets to a nongrantor trust before a gain recognition event may be the next best option. Ideally, the trust should be established in a state without state-level income tax. For instance, a Massachusetts resident could transfer stock in a non-Massachusetts business to a New Hampshire nongrantor trust before selling it. The trust, not the original stockholder, would then recognize the capital gains embedded in the stock at sale without the added burden of the Massachusetts surtax. Similarly, a Washington resident could use this strategy to avoid the new capital gains tax, with the added advantage of being able to create an in-state trust.<sup>7</sup>

Case Study: Exploring Trust Options

Meet Mrs. Nguyen, a Washington state entrepreneur who owns a business worth around $16 million that she built from scratch. The full value of her business, minus any applicable deductions, credits, and exemptions, would be subject to the 7% capital gains tax upon sale. Mrs. Nguyen is married and has three adult children whom she wants to provide for under her estate plan.

Before the enactment of Washington’s capital gains tax, Mrs. Nguyen’s estate planning counsel advised her to set up a grantor trust for the benefit of her husband and children, to which she could transfer her business interest before selling it. As a grantor trust, federal and Washington law would treat Mrs. Nguyen as the “owner” of the trust’s assets for income tax purposes only, meaning that the trust’s income tax liabilities would flow through to her. Mrs. Nguyen could then pay the trust’s tax liabilities without making an additional gift to the trust, allowing the trust assets to grow tax-free and providing another way to shift the Nguyens’ wealth out of their taxable estate.

Now, with most of the sale proceeds subject to the 7% capital gains tax, the Nguyens’ estate planning counsel suggests changing course. By establishing a completed gift nongrantor trust instead, the contributed assets would not be attributed back to Mrs. Nguyen under Washington state law. The Nguyens like the idea of eliminating any state-level capital gains tax but worry about losing the grantor trust’s other benefits. Namely, they wonder about the long-term impact of the compressed federal income tax brackets that apply to nongrantor trusts. Additionally, the Nguyens recognize that they cannot pay a nongrantor trust’s taxes without making taxable gifts to the trust. Is it better to pay the capital gains tax or accept the limitations of a nongrantor trust structure?

Quantifying the Choices

To help answer their questions, we analyzed three scenarios:

  1. no planning prior to the sale;
  2. pre-transaction planning with a Washington grantor trust; and
  3. pre-transaction planning with a Washington nongrantor trust.

Our modeling illustrates how the Nguyens could virtually eliminate their potential estate tax liability using a grantor trust (Display). Alternatively, they could still meaningfully reduce this potential liability via a nongrantor trust, while avoiding roughly $1.1 million in state capital gains. Either way, the family would ultimately preserve at least $20 million more in total wealth after 30 years by engaging in some form of pre-transaction planning.

Weighing the Need for Future Estate Tax Savings versus Immediate Income Tax Savings

When deciding between the two planning strategies, the Nguyens realize that the grantor trust strategy, while optimal from a total wealth perspective, may tie up most of their assets in trust and limit their access to the funds. The Nguyens want to provide for their children—but not at the expense of their own lifestyle.<sup>8</sup> They also wonder about future changes to state and federal estate taxes. With all this in mind, they decide to pursue the nongrantor trust strategy to take advantage of the immediate income tax savings and rely on other planning strategies to address any future estate tax concerns.<sup>9</sup>

Smoothing Your Income Stream

Alternatively, taxpayers in either Massachusetts or Washington could address heightened tax exposure through a combination of state-level deductions and exemptions—and an asset allocation designed to fall shy of the applicable threshold. For example, a resident of either state who anticipates recognizing taxable income or capital gains close to their “ceiling” may consider one or more of the following:

  • Limiting exposure to tax-inefficient investments, either through portfolio repositioning or by packaging such investments in a strategy like private placement life insurance<sup>1o</sup>
  • Leveraging tax-exempt income sources, including state-focused municipal bonds
  • Layering state-level deductions, including those for charitable contributions
  • Deploying tax loss harvesting to reduce net taxable income and capital gains

Staggering Income or Gain Recognition

Spreading out the recognition of income or capital gains over a longer period can also help impacted taxpayers take advantage of deductions and exemption amounts in each state. For instance, a Massachusetts resident could convert a traditional IRA to a Roth IRA over multiple years to keep the additional income recognized under the applicable income threshold. Alternatively, a resident of either state may structure the sale of an appreciated asset as an installment sale, recognizing any resulting gain pro rata over the payment period.

Finally, a charitable remainder unitrust (a “CRUT”) could help level capital gain exposure from the sale of an appreciated asset.<sup>11</sup> A CRUT pays a yearly unitrust payment, which is a certain percentage of the trust assets, to a noncharitable beneficiary, including the trust’s creator and their spouse. Once the trust term ends, the remaining trust assets go to a designated charitable remainder beneficiary, which makes the trust a charitable entity for income tax purposes. This tax treatment allows the trust to avoid gain recognition on the sale of an appreciated asset and instead pass the gain out to the noncharitable beneficiary over the unitrust period. If structured properly, this deferral can allow the taxpayer to reduce the gain recognized in any one year to a level that it will not push them beyond an applicable state-level tax threshold.

A Tale of Two States

Taxpayers facing elevated state-level taxation can learn from the strategies developed for Massachusetts’ “millionaire’s tax” and Washington’s capital gains tax. Leveraging trusts to avoid exposure to such taxes, coordinating your asset allocation with your state-level deductions and exemptions, and deferring recognition of income or capital gains can all help mitigate additional state tax. However, careful planning and execution are necessary to ensure compliance with state and federal tax laws. By staying informed and adapting to the changing landscape of state-level taxation, taxpayers can minimize their tax hit.

Authors
Jennifer B. Goode
Director—Institute for Trust and Estate Planning
Jennifer Ostberg, CFP®
Director—Personal Philanthropy Services

1 Mass. Articles of Amendment 44, Mass. Constitution Article XLIV, as amended by Ballot Question 1 of 2022 (approved Nov. 6, 2022).

2 Quinn v. State of Washington, 520 P.3d 456 (Wn. 2d 2022).

3 RCW 82.87.040.

4  Id. A popular strategy for avoiding state-level taxation involves the transfer of appreciated assets to an incomplete nongrantor trust (an “ING”). As the initial transfer to the trust remains incomplete for gift tax purposes, it does not require use of the transferor’s lifetime exclusion from federal gift and estate tax nor payment of federal gift tax and the assets will enjoy a “step up” in the asset’s income tax basis at the transferor’s death to its then-fair market value. As Washington’s capital gains tax applies to capital gains within an ING, Washington residents cannot leverage this strategy to avoid such tax.

5 Massachusetts laws defines a resident as (i) an individual domiciled in Massachusetts during the year, or (ii) a non-domiciliary who has a permanent place of abode in Massachusetts and spent more than 183 days in the state during the year. 830 CMR 62.5A.2.

6 Washington law defines a resident as (i) an individual domiciled in Washington during the year unless the individual only maintained a place of abode outside of Washington and spent no more than 30 days in the state, or (ii) a non-domiciliary who maintained a place of abode in Washington and was physically present in the state for more than 183 days during the year. RCW 82.87.

7 As assets held in a Washington completed gift nongrantor trust are not attributed to an individual and the capital gains tax applies to individuals only, a Washington resident need not create an out-of-state trust to avoid the capital gains tax. However, a resident may consider other advantages of creating a completed gift nongrantor trust elsewhere—for example, the availability of a self-settled asset protection trust.

8 For more information on how to avoid “overplanning,” see https://www.bernstein.com/our-insights/insights/2023/articles/overplanning-skip-this-wealth-transfer-strategy-mistake.html

9 The Nguyens may consider building into their trust the ability to “toggle on” grantor trust status at some point in the future, either by granting an independent trustee the power to amend the document or appoint the trust assets to a new grantor trust.

10 For more information on private placement life insurance, see https://www.bernstein.com/our-insights/insights/2023/articles/to-save-taxes-on-alternative-investments-pay-attention-to-packaging.html

11 For more information on the structure and use of CRUTs, see https://www.bernstein.com/our-insights/insights/2023/whitepaper/when-the-stars-align-optimal-conditions-for-charitable-remainder-trusts-1.html

The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.

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