Putting the ‘Tax’ Back in Taxachusetts

By Mike Cronin

O’Connor & Drew + Withum

High Profits and ‘Low’ Taxes

By now, everyone with knowledge of the auto industry is aware of the record-breaking profits that have been taking place across the country for the past few years. What few have realized is that this has also come at a time of historically low taxes. Yes, it may be hard to believe that the significant individual income taxes that auto dealers have been paying can be considered ‘low.’ Still, the driver of increased taxes over this timeframe is due to increased income and not the relatively low tax rate.

The Tax Cuts and Jobs Act of 2017 reduced the maximum individual tax rate from 39.6% to 37%. But much more importantly for small business owners, it allowed a 20% of Qualified Business Income (QBI) deduction. This resulted in an effective federal rate on dealership income of 29.6% (20% from 37%) if derived from a pass-through entity – think S-Corporation or Partnership. The lowest top federal tax rate has not been below 30% in the past thirty-plus years. When combined with the Massachusetts state income tax of 5%, most Massachusetts dealerships’ and related real estate incomes were being taxed at a collective 34.6% at the individual level.

Massachusetts Taxes

Contrary to popular belief, Massachusetts and its voters did not always increase taxes for its constituents. In November 2000, the Massachusetts voters successfully passed a reduction to the state income tax from 5.85% to a flat 5%. Then in September 2021, the Massachusetts Legislature enacted an elective pass-through entity (PTE) tax to provide pass-through entities with the ability to deduct state taxes at the federal level while passing the credit to the individual owners. The PTE election resulted in an approximately 1% decrease in total individual taxes to owners of pass-through entities, bringing the total tax noted above down from 34.6% to 33.6%. And finally, in November 2022, refunds on personal income tax liabilities were paid due to excess tax revenue collections set by Chapter 62F of the Massachusetts General Laws.

However, the state tax landscape changed in November 2022, when Massachusetts voters passed a law that imposes an additional 4% personal income tax for its high-income earners, referred to as the “millionaires tax.” The result is that every dollar of taxable income over the initial $1 million threshold will be taxed at 9% starting with the 2023 tax year. This means that every dollar over the first $1 million from your Massachusetts dealerships and real estate pass-throughs will be taxed at a combined 38.6% instead of 34.6%. This is an additional $40,000 in taxes per million dollars over the income threshold.

Minimizing the 4% Impact

With the dealership market remaining strong in 2023, there may not be a way to avoid this additional tax entirely, but there are some ways to mitigate the impact.

• Filing Separately: For numerous tax instances, there are benefits to being married and filing a joint return. This is not one of them. The $1 million threshold is the same for both single and joint tax returns. Therefore, if both you and your spouse have substantial taxable income, under current law you could file separately in Massachusetts (while still filing jointly federally) and reduce the burden of the 4% tax. If you both happen to make over $1 million, then this is a way to shelter an additional $1 million of income or $40,000 in state taxes. (Note: The Legislature presently is deliberating an amendment to the law to eliminate this loophole.)

• Selling Assets: If you are planning to sell an asset or group of assets in 2023 or going forward, you might want to consider setting up the sale as an Installment Sale, where you receive the proceeds over time. In this case, you would also defer the associated gain. Spreading the income for multiple years could reduce or eliminate the impact of the 4% tax.

• Moving Out of Massachusetts: As taxes increase and more work is done remotely, many Massachusetts taxpayers are looking to relocate to low- or no-income tax states. However, a non-resident taxpayer would still be taxed on the income derived from Massachusetts, including your in-state auto dealership.

Tax Day 2024

Even if you can take advantage of these planning ideas, based on the significant profitability in the auto industry that looks to continue throughout 2023, you will likely have at least a portion of your income over the $1 million threshold. And this extra tax money will likely be coming out of your pocket in April 2024. Most auto dealers will be ‘safe-harbored’ on their federal and state income tax estimated payments, meaning they will pay in tax estimates during 2023 based on 2022 tax amounts. However, 2022 did not include the additional 4% millionaires tax, so, likely, this amount will not have been paid in by the time your tax return comes due. Remember this during the year so there are no surprises at the tax deadline.

On top of that, dealerships that are set up as S-Corps or Partnerships have been taking advantage of the Massachusetts PTE tax, which results in the dealership paying the Massachusetts taxes on behalf of their owners. The problem is that the Massachusetts PTE tax is a 5% tax and does not consider the additional 4%. The additional 4% cannot be taken as a deduction the same way the initial 5% tax is currently, and the owners will be responsible for the additional 4%.

To summarize, if your taxable income for 2023 is expected to be on pace with or greater than 2022’s and you will make over $1 million, then you should expect to be writing the Commonwealth a check next April – and you will have the voters of Taxachusetts to thank for it.