If you’re a business owner living in Massachusetts, you may one day sell your company for more than $1 million. Because of the so-called “millionaire’s tax,” you may have to give up a larger portion of the proceeds from that one-time event unless you start your financial planning now.
Business owners dedicate thousands of hours to crafting their skills. Owners are so passionate about delivering meaningful customer service that they intentionally reduce their income by hiring employees. They sacrifice time with their family to be able to support them. Often, they carry the anxiety and fear of putting payroll on a credit card, not closing that much-needed deal, or getting run out of business due to the competition of a national disruptor. Being a business owner is like chewing glass while staring into the abyss, often while feeling alone in this misery.
There is an upside to being a business owner. Entrepreneurs enjoy the psychic reward of providing value to customers, creating jobs, and supporting their community through charitable donations and generous sponsorships. Also, the entrepreneur class is the most likely to achieve an income exceeding $1 million.
Additionally, when an owner sells a company, that one-time event may push their income over $1 million in the year of the transaction. Therefore, business owners are disproportionally affected by the Massachusetts Millionaires Tax, more formally known as the “Fair Share Amendment.”
Massachusetts voters approved the Millionaire’s Tax in November 2022. It was the first time the state’s constitution was amended in 22 years. The tax creates a 4 percent surtax on income over $1 million, beginning this year. The MMT raises the state income tax rate to 9 percent on income over $1 million. It is a flat tax that applies to earned income as well as long-term capital gains. The MMT makes Massachusetts one of the highest-income tax states.
Although the millionaire’s tax is a state penalty, I am reminded of a quote from Learned Hand, a senior judge of the U.S. Court of Appeals for the Second Circuit. In a landmark case, the predecessor to today’s United States Tax Court found in favor of the taxpayer. Hand cited, “Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”
How business owners can work around the Massachusetts Fair Share Amendment
Hold Investments and Cash in the Right Accounts
As an owner of Berkshire Money Management, I’ve become more attracted to the current yields of bond investments compared to a year ago. Some non-bank money market accounts are paying more than 5 percent. Ideally, investments generating interest payments should be in qualified tax-deferred accounts. However, if that’s not an option, investors can consider either Massachusetts-based municipal bonds or Treasuries, neither of which would be subject to the MMT.
Live in a More Tax-Friendly State (Or Make it Look Like You Do)
You could move out of Massachusetts to a state that is more income-tax-friendly. Alaska, Florida, South Dakota, Texas, Washington, Nevada, and Wyoming have no state income taxes. New Hampshire is also on that list, but be aware that there is a 5 percent tax on dividends and interest (although that is being phased out).
If you wish to reside in Massachusetts, setting up an irrevocable trust domiciled in a state with no income taxes can help you avoid the MMT. There are rules to consider. For example, you must be careful about what year you withdraw from the trust to shield you from Massachusetts-sourced income.
Retitle Company Ownership
Tom, a dental practice owner in Wellesley, knows he’d lose most of his revenue if he moved to another state. Tom wants to retire soon and plans to fund his retirement by selling his company. Tom made a financial plan to minimize his tax obligations to make it more likely he would not run out of money in retirement. To avoid the MMT, he transferred the company’s shares into an Incomplete Non-Grantor Trust. When Tom decides to retire, the business sale will not be taxed in Massachusetts.
Instead of using the ING Trust, Tom could have also considered selling the practice using an installment sale. As a shareholder-employee of Subchapter S Corporation, Tom had to follow Internal Revenue Service guidance and pay himself “reasonable compensation” via W-2 wages. However, like many owners, a good chunk of Tom’s additional income came from owner distributions. Tom could have sold part of his business, which would have reduced distribution income.
Make Intelligent Charitable Contributions
If you are over the age of 70 1/2, you can make your required minimum distribution from an Individual Retirement (IRA) account directly to a qualified charity. That distribution will not be considered income, so you could avoid paying the MMT as well as other state or federal taxes.
Take Advantage of a Loophole
Under current Massachusetts law, married tax filers can avoid the MMT by declaring themselves single on state taxes, even while simultaneously realizing the deductions from filing jointly on their federal income taxes. This loophole allows each tax filer to receive a $1 million exemption from the 4 percent income tax surcharge. That’s a tax reduction of up to $40,000. Full disclosure: I found this loophole on the MassBudget.org website. Mass Budget pointed out that other states with similar opportunities eventually closed that loophole. Use it while you can, but check with your accountant to be sure it remains when you file.
Throughout their working career, many business owners have contributed more total dollars in taxes personally and through employment, property, excise, and sales tax than the average taxpayer. You’ve paid what some people might consider your “fair share.” It’s your right to avoid paying more than you legally should.
This article first appeared in the Berkshire Eagle on September 27, 2023.