Q: What is Upstream Gifting and How Can it Minimize My Taxes?
A: The average American is generally unconcerned with federal estate taxes because exclusions are historically high (in 2023, an individual can exclude a whopping $12.92MM from his or her estate before any estate taxes are due; $25.84MM for a married couple). However, individuals with non-taxable estates can still take advantage of sky-high exemptions to minimize a different type of tax: capital gains tax. Specifically, they can make use of an older generation’s available exemption to re-adjust the basis of highly appreciated capital assets through a strategy known as “upstream gifting”.
Typically, when a donor makes a lifetime gift to any donee, the donor’s basis in such asset “carries over” to the donee. Any gain recognized on the sale of such asset (i.e., the sale price less the basis) is typically taxed between 15–20% (plus an additional 3.8% net investment income tax for some). However, if transferred upon the donor’s death, the basis is instead “stepped up” (i.e., readjusted to the fair market value upon the donor’s death), eliminating any built-in gain.
For example, imagine in 2008 Donor purchases 50,000 shares of AMZN for $2.50/share, resulting in a $125,000 basis. Donor gifts the shares, then valued at $181 per share, to father. Father passes away in 2021 when Amazon stock is worth $181 per share, leaving the 50,000 shares to Donor in his estate plan, owing no estate tax due to his large available estate tax exemption. The shares bequeathed to Donor receive a new “stepped-up” tax basis of $181.00 per share eliminating a built‑in gain of $178.50 per share, resulting in savings of $1.34MM–$1.79MM in capital gains tax if all the Amazon shares are sold.
Savvy investors or small business owners who realize this may be tempted to gift highly-appreciated assets to parents with modest estates. But they should understand the risks, namely loss of control, assets being reachable by a parent’s creditors, utilization of the transferor’s own exemption, survival requirements, and inadvertently creating a taxable estate for the parent.
Instead, an individual might avoid these traps by putting the highly-appreciated assets in an irrevocable trust for benefit of himself and his parent (preferably in a New Hampshire asset protection trust), and giving each parent a formulaic testamentary general power of appointment. This power, which merely allows the parent to direct distribution to any person (including themselves), triggers step-up even when unexercised. Any person looking to engage in this technique should first consult an experienced estate planner.
Know the Law is a bi-weekly column sponsored by McLane Middleton. Questions and ideas for future columns should be emailed to knowthelaw@mclane.com. Know the Law provides general legal information, not legal advice. We recommend that you consult a lawyer for guidance specific to your particular situation.