As we all contemplate the implications of the 2022 midterm elections, we must be mindful to focus not only on individual elections but also on state-specific ballot referenda. One such referendum of note is the so-called Massachusetts “millionaire tax” that state voters approved by a margin of about 52% to 48%.
What Is The New Tax?
The millionaire tax has been a work in progress for several years, in part because it required an amendment to the Massachusetts Constitution, which previously prohibited a graduated income tax. Under the newly approved provision, Massachusetts taxpayers will now pay a tax of 4%, on top of the regular income tax of 5% (12% for short-term capital gains), on taxable income over $1 million. The threshold will be adjusted in subsequent years for inflation.
The millionaire tax will apply starting in tax years beginning on or after January 1, 2023. Proceeds will be earmarked, according to the text of the ballot question, “for quality public education and affordable public colleges and universities, and for the repair and maintenance of roads, bridges and public transportation.”
How Many People Will It Affect?
According to The Center for State Policy Analysis at Tufts University, as of 2019, there were 21,000 Massachusetts taxpayers with incomes over $1 million. Keep in mind, however, that the number of taxpayers who ultimately could be affected by the millionaire tax is likely much higher for at least a couple of reasons. First, given the impact of inflation, market gains, tight labor conditions, and other factors, income at the upper echelons of the income spectrum generally has increased. Second, some people have, and will continue to have, “lumpy” income that in some years exceeds $1 million and in others does not.
Are There Any Planning Opportunities To Mitigate The New Tax?
For people who pay Massachusetts taxes and are likely to be impacted by the millionaire tax, there are opportunities to deploy mitigation strategies. Importantly, however, some are more practical and impactful than others.
1. Move to another state. In general, changing residency solely for tax purposes can be seen as the ultimate example of “allowing the tax tail to wag the dog.” Such life decisions are complex and really should be made in the context of personal considerations outside taxes.
That said, for those who may be contemplating a move to another state, such as New Hampshire, Florida, or another no/low-income tax state, doing so soon can offer an opportunity to avoid the millionaire tax. Keep in mind that, especially for those who want to move but cannot do so before 2023, residency changes can occur during a taxable year, enabling a taxpayer to assert partial residency for any year of change.
Changing one’s residency, however, requires great care and must be done with full substance—not just form. The Massachusetts Department of Revenue has the right to audit anyone who claims to change their residence and does not do so fully. Note also that, in some cases, it may be impossible to avoid Massachusetts taxation—even for non-residents—if, for example, a non-resident works in the state or earns business or other income taxable there. Owners of vacation homes in Massachusetts need to be careful not to spend more than 183 days in the state each year, or they will automatically be considered a resident.
2. Shift income and expenses between years. Prior to 2023, there is a limited opportunity for taxpayers to accelerate taxable income, including income from sales of appreciated assets, into 2022, before the millionaire tax becomes effective. Again, however, it is important not to allow taxes to be the sole consideration in making complex financial decisions.
After 2022, a similar strategy, especially for those whose taxable income changes significantly from year to year, is to shift income or expenses to lower income or higher income years, respectively. For example, for those who are in control of the timing of bonus payments, it may make sense to accelerate or defer payments into years in which taxable income is otherwise less than the threshold. On the expense side, if the expense is deductible, then it might make sense to accelerate or defer it into years in which income is otherwise greater than the threshold.
3. Defer some charitable contributions into 2023. One example of an expense that is not currently deductible in Massachusetts, but might become deductible as soon as 2023, is charitable contributions. For many years, charitable contributions have not been deductible in Massachusetts, even though they were authorized many years ago for future years in which the Commonwealth was financially stronger. It appears that 2023 might be such a year, possibly offering a chance for some taxpayers to “bunch” their charitable contributions into 2023 or subsequent years to reduce the portion of their taxable income subject to the millionaire tax.
4. Carefully consider your choice of business entity type. Income from passthrough entities (“PTEs"), such as partnerships and S corporations, has traditionally been taxable to the individual owners, rather than to the entity. Massachusetts, however, has a special rule that taxes S corporations with at least $6 million of income an additional 2-3%. With the millionaire tax, this effectively means that some S corporations may be taxed by Massachusetts at a 12% rate. For these S corporations, it may be worth considering a partnership structure or even that of a traditional C corporation. While the base corporate tax rate is 8%, the additional flexibility around timing of dividend distributions may allow owners to avoid the millionaire tax.
And just to make the forthcoming tax picture even more complex, Massachusetts currently allows PTEs to elect to pay the business-related income taxes of their owners at the entity level. While this may still be a good strategy for minimizing federal taxes, it does not save business owners from the millionaire tax. Massachusetts treats the PTE payments as a credit, which does not decrease taxable income, rather than as a deduction.
Of course, we must await further guidance from Massachusetts to understand fully how the millionaire tax will be administered. Nevertheless, it does appear that planning around the millionaire tax in its current form could offer meaningful tax savings. Indeed, this type of planning could become even more important in the future, as the door has now been opened to graduated income tax rates in Massachusetts. Whether there are additional rate tiers added in the future is anyone’s guess, but if other states are any guide, vigilance is warranted.
Michael Nathanson is CEO of The Colony Group. Justin Gilmartin is senior vice president of tax services at The Colony Group.