With the federal gift and estate tax exemption at $11.40 million for 2019, people whose estates are below the exemption amount are shifting their focus to income tax reduction. High-income taxpayers — particularly those who live in high-income-tax states — may want to consider incomplete non-grantor trusts, which make it possible to eliminate state taxes on trust income.

Defining an Incomplete Non-Grantor Trust

Generally, trusts are classified as either grantor trusts or non-grantor trusts. In a grantor trust, you, as “grantor,” establish the trust and retain certain powers over it. You’re treated as the trust’s owner for income tax purposes and pay taxes on income generated by the trust assets.

In a non-grantor trust, you relinquish certain controls over the trust so that you aren’t considered the owner for income tax purposes. Instead, the trust becomes a separate legal entity, with income tax responsibility shifting 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.

Ordinarily, when you contribute assets to a non-grantor trust you make a taxable gift to the trust beneficiaries. By structuring the trust as an incomplete non-grantor trust, you can avoid triggering gift taxes, or tapping your gift and estate tax exemption. This requires relinquishing just enough control to ensure non-grantor status, while retaining enough control so that transfers to the trust aren’t considered completed gifts for gift-tax purposes.

Analyzing the Benefits

Although the trust will allow you to receive distributions, assets you place in the trust should produce income that you don’t need. If you take money out, trust taxable income could follow to you and be taxed in your state of residence.

Incomplete non-grantor trusts aren’t right for everyone. It depends on your particular circumstances and the tax laws in your home state.

While this strategy can produce significant state income tax savings, it may increase federal income taxes, depending on your individual tax bracket. Non-grantor trusts pay federal income taxes at the highest marginal rate (currently, 37%) once income reaches $12,700 for 2019, while the 37% rate threshold is $612,350 for married couples filing jointly and $510,300 for singles and heads of households. If you’re not in the 37% bracket, the increased federal income taxes the incomplete non-grantor trust would pay might outweigh the state income tax savings.

Also, if federal estate taxes aren’t a concern now but could be in the future — such as if your estate could exceed the estate tax exemption when it drops to an inflation-adjusted $5 million in 2026, as currently scheduled — be sure to consider the potential estate tax consequences. Incomplete gifts remain in your estate for estate tax purposes.

Is it Right for You?

To determine whether an incomplete non-grantor trust is right for you, weigh the potential state income tax savings against the potential federal estate and income tax costs. Contact us with any questions.

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