With the threshold for federal estate taxes set at $5.49 million this year (it adjusts each year for inflation), very few estates have to file a federal estate tax return. In contrast, the Massachusetts threshold is $1 million, meaning that many more estates must file a Massachusetts return. For estates that fall between $1 million and $5.49 million, it can still make sense to file a federal return if the decedent left a surviving spouse.
This is for two reasons: portability and capital gains step up.
The surviving spouse may elect to take over the unused estate tax credit of the deceased spouse by making a portability election on a federal tax return. Here's what this means. Let's assume that Mr. Brown dies with an estate worth $2.49 million, meaning that he doesn't need $3 million of his $5.49 million estate tax credit. If Mrs. Brown files an estate tax return for Mr. Brown and elects portability, then she can, in effect, inherit Mr. Brown's unused $3 million credit and add it to her own $5.49 million credit, permitting her to leave $8.49 million federal estate tax free at her death.
For almost everyone, this is irrelevant. But just in case Mrs. Brown inherits a lot of money, strikes oil, wins the lottery, or owns stock options in a startup that goes public, she may not want to forego this opportunity to increase her estate credit. This is especially true since Mr. Brown's estate is over $1 million, meaning that she has to file a Massachusetts estate tax return. She essentially needs to fill out a federal estate tax return in order to file the Massachusetts estate tax return, so there's not much more work or expense to file the federal return as well.
QTIP Trusts and Capital Gains
The second reason for the surviving spouse to file a federal estate tax return applies to more people, but only those with so-called QTIP trusts. (QTIP stands for qualified terminable interest property, which you should feel free to forget.) The significance is that QTIP trusts permit the surviving spouse to choose how to treat the trust property for tax purposes, whether it is or is not in her estate. And she can have the property treated one way for federal purposes and the other way for Massachusetts purposes. Depending on the choice she makes, her children may pay more or less in capital gains when they later sell the property.
Here's how this works. Let's say that Mr. Brown left his estate to Mrs. Brown in a QTIP trust. In Massachusetts, Mrs. Brown would split the trust in two shares, treating $1 million (the amount Mr. Brown can leave tax free) as not belonging to her for tax purposes so that it will not be taxed in her estate when she dies and $1.49 million as belonging to her so that it will qualify for the marital deduction and not be taxed on Mr. Brown's death.
Let's further assume that Mr. Brown's trust owns a house on Martha's Vineyard that's has a fair market value of $2 million, but which Mr. Brown purchased for $1 million. If Mr. Brown had sold the property during his life, he would have realized $1 million of capital gain and paid about $250,000 in taxes. But at his death, the tax basis in the property was adjusted to the value at death -- $2 million -- a so-called "step-up" in basis. This means that if Mrs. Brown were to sell the house, she would not realize any capital gains and would not have to pay any tax.
So far, so good. But what if Mrs. Brown chooses not to sell the house and it appreciates so that it's worth $3 million when she dies? Depending on how the house is held, there may be two unfortunate results. First, since at least some of the house value will be in the portion of the trust for which she made a Massachusetts QTIP election, it will be subject to estate tax at her death. This portion of the house will also get a step-up in basis, but -- and here's the rub -- only for Massachusetts purposes. When the children sell the house for $3 million, they will realize $1 million of capital gain -- the appreciation after their father's death -- and have to pay federal capital gains taxes for the entire gain and Massachusetts taxes on a portion of the gain.
But, this could be avoided if Mrs. Brown had filed a federal estate tax return upon Mr. Brown's death and made a federal QTIP election for the entire value of Mr. Brown's estate. Then everything in the trust would be includible in Mrs. Brown's estate for federal tax purposes and receive a step-up in basis at her death, avoiding the taxes on capital gain when the property is sold after her death.
This explanation may be totally confusing. The bottom line, nevertheless, is that surviving spouses need to consider filing federal estate tax returns along with Massachusetts returns for their deceased spouses' estates. Every situation is different, so qualified estate planning and tax professionals are needed to advise on what makes the most sense in each case. The example above uses real estate, but the same rules apply to other property that may appreciate, including stock and artwork.