Now that the federal gift and estate tax exemption has reached an inflation-adjusted $5.43 million, many people are shifting their estate planning focus to income tax reduction. One potentially attractive strategy for high-income taxpayers, particularly those who live in high-income-tax states, is an incomplete nongrantor trust.

These trusts — established in favorable tax jurisdictions, such as Delaware, Florida or Nevada — make it possible to reduce or even eliminate state taxes on trust income. And, as an added benefit, they offer asset protection against creditors’ claims.

How it works

Trusts generally are classified either as grantor trusts or nongrantor trusts. With a grantor trust, the person who establishes the trust (the “grantor”) retains certain powers over the trust and, therefore, is treated as the trust’s owner for income tax purposes. The grantor continues to pay taxes on income generated by the trust assets.

With a nongrantor trust, the grantor relinquishes certain controls over the trust so that he or she isn’t considered the owner for income tax purposes. Instead, the trust becomes a separate legal entity and income tax responsibility is shifted to the trust itself. By setting up the trust in a no-income-tax state (typically by having it administered by a trust company located in that state), it’s possible to avoid state income taxes. The grantor is entitled to receive distributions from the trust, usually at the discretion of a distribution committee.

Ordinarily, when you contribute assets to a nongrantor trust, you make a taxable gift to the trust beneficiaries. To avoid triggering gift taxes, or using your gift and estate tax exemption, it’s important to structure the trust as an incomplete nongrantor trust. In other words, you should relinquish just enough control to ensure nongrantor status, while retaining enough control so that transfers to the trust aren’t considered completed gifts for gift-tax purposes.

One important caveat: This strategy won’t work if your home state imposes its income tax on out-of-state trusts based on the grantor’s state of residence.

An example

Suppose you live in a state that imposes a 10% income tax and you have a $5 million investment portfolio that earns a 7% annual return, or $350,000 per year. By using the incomplete nongrantor trust strategy described above, you can save $35,000 per year in taxes (10% of $350,000), assuming your state doesn’t extend its income tax to out-of-state trusts established by state residents.

Assume further that you reinvest your tax savings in order to grow your portfolio more quickly. Over a 20-year period, an incomplete nongrantor trust would produce a total benefit (state income tax savings plus earnings on reinvested tax savings, presuming half of the earnings are attributable to growth and thus not currently taxed, with the other half taxed at the highest marginal rate) of more than $1.3 million.

Consider a cost-benefit analysis

Incomplete nongrantor trusts aren’t right for everyone. It depends on your particular circumstances and the tax laws in your home state. Also, while this strategy produces significant state income tax savings, it could also increase federal estate and income taxes. Why? Because incomplete gifts remain in your estate for federal estate tax purposes. And nongrantor trusts pay federal income taxes at the highest marginal rate (currently, 39.6%) once income reaches $12,300 (for 2015).

To determine whether this strategy is right for you, ask your advisor to conduct a cost-benefit analysis that weighs the potential state income tax savings against the potential federal estate and income tax costs.