Fundamentally, estate plans are designed to pass assets to future generations as efficiently as possible. Nevertheless, it might be beneficial to employ an “upstream transfer” to eliminate built-in gains on highly-appreciated or income-producing assets. This technique achieves an income tax basis adjustment by purposefully causing inclusion of certain assets in an ancestor’s non-taxable estate at death—thus utilizing a relative’s lifetime estate and gift tax exemption that would otherwise be wasted. The assets then revert back downstream to the original owner or his descendants with a new basis. A basic illustration follows.
An individual, S, owns an investment asset with a tax basis of $200,000 and a fair market value of $2,000,000. Under the current unified credit, both S and his elderly father, F, have unused exemption amounts. In contemplation of selling the asset, S realizes that he could be subject to $428,400 in long-term capital gains tax on the sale (ignoring additional state income tax, if applicable). Alternatively, if the sale was not imminent, S could first transfer the asset upstream by gifting it to F, who, incidentally, has a relatively short life expectancy. When F dies, the asset will be included in F’s estate, thus affording the inheritor, likely S, a “stepped-up” basis equal to the fair market value of the asset at F’s date of death. This adjusted basis of $2,000,000 will reduce (or eliminate) forthcoming capital gains tax on the impending sale or, if S instead retains the asset, will be valuable for depreciation and future transfer purposes. Additionally, no transfer tax would be imposed on the upstream gift or the subsequent downstream (return) bequest.
While an upstream transfer can be an excellent tax planning tool in appropriate circumstances, a few notable caveats apply. The current gift and estate tax rate (40%) is significantly higher than the top capital gains rate (20% + 3.8% net investment income tax). Therefore, this technique is unsuitable (without more complex planning) if a taxable transfer could result, such as in scenarios involving individuals who have previously exhausted some or all of their unified credits, rapidly-appreciating asset, or an impending decrease in the lifetime exemption. Additionally, to ensure upstream transfers are respected, one must observe Internal Revenue Code § 1014(e). This section precludes a basis adjustment—thwarting the objective of the plan—if the appreciated property is transferred back downstream to the original donor within one year of the upstream transfer. The transfer must also constitute a completed gift, evidenced by the original owner’s release of control over the asset. Thus, the transferor is wise to choose an upstream transferee whom he trusts to execute the plan as designed, rather than disposing of the asset pursuant to his own discretion or different agenda. Moreover, upstream transfers expose the asset to the risk of the upstream transferee’s creditors.
To alleviate some of the above issues, the owner of the asset could effectuate the upstream transfer through a trust agreement. For example, S could establish a trust that grants F a testamentary general power of appointment, causing inclusion in F’s estate. F could use this power to direct the property back to S at F’s death, generating the desired fair market value basis adjustment. If S intended for a future generation to eventually receive the asset, and provided F had available Generation Skipping Transfer Tax exemption, F could also exercise his power to direct the property to S’s son, a permissible appointee, allowing the asset to avoid future transfer taxes.
Although not useful in all situations, upstream transfers can be an extremely powerful compliment to certain deliberate and well-executed tax and estate plans.
With questions on this or any other tax or estate planning matter, please feel free to contact Jana Simons at or firstname.lastname@example.org.