How to use trusts to save big-time on state income taxes

Most tax strategies center on minimizing federal income taxes, since they account for the lion's share of taxes a person might owe. But in some states, income-tax rates are themselves in the double digits and can add mightily to tax bills.

Over the last decade or so, one strategy has been gaining in popularity among wealthy individuals and families and their tax advisors. They use trusts to limit their exposure to state income-tax rates. ING trusts, which stands for incomplete gift non-grantor trusts, can shift the tax exposure out of a high-tax state, such as California, to a state with no state income tax, such as Delaware, Nevada and Wyoming.

"It's interesting that there's a real interest in this, because it applies to so few people," said Heather Flanagan, senior vice president and wealth director at PNC Wealth Management.

The first thing to know about trusts is that they come in two varieties: grantor and non-grantor. Grantor trusts pass through all their tax exposure to the person who created the trust. Non-grantor trusts, where the person who created the trust gives up control of trust, don't.

"A non-grantor trust sets the trust up as its own taxing entity, and all those tax consequences are at the trust level, not the grantor level," Flanagan said.

Trusts are taxed at the highest federal rate of 39.6 percent, plus the 3.8 percent Medicare surtax, at a much lower threshold than people are — $12,400 vs. $415,051 for individuals and $466,951 for married filing jointly. This is a non-issue for wealthy individuals, since their income already puts them in the highest tax bracket.

States also impose an income tax on the trust, and beneficiaries owe federal and state income tax on any distributions they receive. But states can only make a state income-tax claim if they can show a substantial connection to the income, known as nexus.

Where things get confusing is that each state has its own rules about which trusts they consider to be residents of their state. For example, Maryland considers a trust a resident if it's administered in the state. New Jersey looks at who the grantor is. California goes by who the trustee and the beneficiary are.

"Sophisticated planners realized they could do jurisdictional planning to help wealthy families minimize or avoid home-state tax," said Jeff Wolken, national director of wealth and fiduciary planning for Wilmington Trust.

For example, a trust located in a high-tax state such as New Jersey could avoid state income taxes by structuring it differently. "Just swap out the New Jersey trustee for a Delaware trustee," he said.

A fairly new strategy, the ING has been gaining popularity over the last decade and takes these tax-avoidance strategies a step further. INGs can help wealthy individuals reduce the state income tax at the trust level, particularly if they're about to have a substantial gain.

Let's say a successful executive at a biotech company in California is eyeing retirement, and selling her $10 million in stock options will factor heavily into that plan. Because her basis is very low for those options, practically the entire amount will be taxable for state income tax.

But if she creates an ING trust in neighboring Nevada a year or two before the transfer of the stock options, she can avoid paying California's state income tax on the gain, a tax bill of more than $1 million.

Experts caution that anyone attempting this strategy should follow specific steps to avoid the perception that the trust is simply a tax dodge.

"That's why you must set up the trust before there's ever any letter or intent or sales discussion," said PNC's Flanagan about taxpayers who use the trusts before the sale of a business.

INGs also help with estate-tax planning, said Steven Oshins, a Las Vegas attorney who focuses on estate planning and asset protection.

"When you put your assets [in an ING], it's an incomplete gift for tax purposes but a completed transfer for income-tax purposes," he said.

In other words, because the grantor retains control of the assets, it's an incomplete gift and won't require the person setting up the trust to use up his or her lifetime unified credit for gift and estate taxes.

"That's only because the federal income-tax rules are not completely compatible with the federal estate- and gift-tax rules, so it allows this loophole," Flanagan said.

The trusts also take advantage of their states' generous credit protection laws that shield trust assets from creditors.

As you might expect, state governments aren't too happy about these tax-avoidance moves. New York, for example, outlawed non-grantor trusts in 2013. No matter where the trust is located, a grantor will be taxed for any income the trust generates.

Pennsylvania tried to tax the Delaware trust of a one-time resident by sending the grantor's widow a tax bill for $500,000. A Pennsylvania court ruled in 2013 that there wasn't sufficient connection between the state and the income generated by the trust. That doesn't mean that states won't keep trying to fill their coffers with income tax from trusts.

"The states have gotten more aggressive in pursuing income," said Abbot Downing's Lisa Featherngill. "For a lot of people, the uncertainty is too high."

— By Ilana Polyak, special to CNBC.com