Upstream basis planning is a trust strategy that can save wealthy people on their capital gains taxes and income taxes associated with highly appreciated assets.
First, upstream basis is not about fishing! It is about using your estate plan to reduce capital gains or income tax.
While estate taxes only affect the wealthiest of the wealthy, with the runup in stock prices and real estate values, capital gains taxes can be a real issue for many people. One possible solution involves using a tool called an upstream power of appointment trust.
At its core, this strategy requires someone to include an elderly and much less wealth relative, such as a parent, as an additional trust beneficiary. But there's much more to it.
- Basis: The amount that you reduce a price to determine the taxable gain. Often, this amount will be your historical cost, which may be adjusted for depreciation or other items (for the accountants who may be reading).
- Step-up (in basis): If I bought a fixer-upper for $100,000 and later sold my home to you for $400,000, then my taxable gain would be $300,000. However, if the home I sold you was my father's home, which was being sold to distribute his estate to myself and my eight siblings, then the basis (cost) would be increased to the fair market value as of my father's date of death. This increase is referred to as the “step-up in basis.” In this case, there would be no capital gain on the sale and no taxes owed.
- Lifetime estate tax exemption: The lifetime federal estate and gift tax exemption is presently $12.06 million per person. For a married couple, that is $24.12 million, which represents the value of assets that can be passed from you to your children or other loved ones free of estate (death) tax. But be careful, if you survive to Jan. 1, 2026 (and I plan to do so), that lifetime exemption drops to just under $6 million, which is adjusted for inflation. For a married couple, that means the $24.12 million estate gift tax exemption dropped by about $12 million. This tax exemption is a use-it-or-lose-it proposition.
How Upstream Planning Works
Upstream planning involves transferring certain appreciated assets to older or other family members with a shorter life expectancies. Because this person will die sooner, a basis step-up is triggered sooner when that person dies. So, that person dies and I obtain a basis step-up on my property, saving income taxes for me on depreciation while I own the property (if appropriate) and from capital gains on a future sale of the property. In other words, using an uncle or your grandfather to obtain substantial tax savings.
This is a good time to consider this type of planning because many people are not concerned about paying or owning estate tax. However, we are all concerned about paying too much in income taxes or capital gains taxes.
To accomplish this result, we would need to give our elderly uncle a general power of appointment over the asset. (See Internal Revenue Code (“IRC”) section 2041.) This section says that you must give your uncle a power to appoint the asset to “his estate, his creditors or the creditors of his estate.” Providing such a power will include the value of that property in his estate (not yours), ensuring the basis step-up and the income tax savings. We should not grant this power lightly, as a general power of appointment means your uncle could give this property to anyone in the world, including himself, at your death.
What about the Loss of Control of the Assets?
We all want to save tax, but what if my Uncle Joe exercised that power in a way I did not like? While the IRC rules do not permit me to have Uncle Joe get my permission, we can require him to get the permission of an independent third party, such as my CPA or best friend. Note also that we do not even have to tell Uncle Joe that he has this power to take control of or change the distribution of this property. So, we can craft this plan utilizing a trust with provisions to effectuate our desired result. While this may seem odd or even unethical for Uncle Joe to not know he has this power at first blush, this is my property and I have the power to do what I want with my property. The IRS rules do not require that he actually know of this power. That said, best practice is to designate someone you know and trust who understands and respects your true wishes.
We can take this concept further by utilizing a formula clause so that we can receive a basis step-up and prevent a basis step down if the property or asset values fall. We are all so used to property and asset values increasing, we may forget 2008 or other economically bad years. A wide range of assets lost value. A formula clause is a little like having your cake and eating it too. Getting a basis step-up but avoiding a basis step-down. A formula clause can provide a basis step-up, and also prevent a basis step down if the property loses value, such as in a recession which we now fear.
What can we do with such a planning tool? Imagine holding two assets. The first asset has a zero basis and a $10 million fair market value. The second asset has a fair market value of $1 and a basis of $10 million. A low basis asset may arise if an asset is depreciated, increased dramatically as we saw in the past with crypto currency. A zero or no basis asset can arise from paper transactions, such as the issuance of equity interests (corporate or partnership) debt securities and right or options to acquire equity interests, such as stock or debt securities in the future. At death, a sale of the first asset is made tax free (no capital gain). The second asset can be sold for $1 triggering a tax loss of $10 million to be used to offset other income.
Finally, for the last ingredient, utilize an asset protection style trust with discretionary distributions of income and principal. Consider a third-party trustee or distribution trustee to better protect the appreciated assets from the risks around each of us and those risks that may be related to Uncle Joe. These risks could include Uncle Joe's divorce, lawsuits, creditor claims or even bankruptcy.
Some Things to Keep in Mind
- With proper planning the beneficiary does not need to survive for any stated period of time.
- With proper planning, you would not lose access to the assets receiving the basis increase.
- You must be cautious and careful with whom you choose to hold that power. First, that person could divert the assets at your death to persons that you don't wish to receive those assets. Also, a general power of appointment could expose assets to creditor claims or other liabilities of the person holding this broad power as described above.
The Bottom Line
Upstream basis planning is just one of several ways that your estate plan can be used to pay less tax.
This article was provided by John M. Goralka, and originally published in Kiplinger's Personal Finance Magazine, and brought to you by the Ronald J. Fichera Law Firm, where our mission is to provide trusted, professional legal services and strategic advice to assist our clients in their personal and business matters. Our firm is committed to delivering efficient and cost-effective legal services focusing on communication, responsiveness, and attention to detail. For more information about our services, contact us today!
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual.