Since the passage of the Tax Cuts and Jobs Act of 2017, a rare estate planning technique has become increasingly attractive to families who own appreciated assets. Called “upstream gifting” by some, the technique involves making gifts of appreciated assets up the family tree to parents or grandparents, rather than more typical downstream gifts to children or grandchildren. An important benefit of making upstream gifts is that at the older recipient’s death, the appreciated assets will receive a step-up in income tax basis. Those that receive the appreciated assets from the older generation should then be able to sell the assets promptly with no capital gains tax due.

Upstream gifting was virtually unheard of when the federal estate tax exemption amount was a modest $600,000, as it was in the late 1980s and into the 1990s. Because the estate tax rate was 55% during that period, the prevailing strategy for wealthy individuals was to transfer assets down to younger generations as quickly as possible so that any appreciation could occur in the younger generation’s hands, rather than in the wealthy individual’s estate.

In recent years, however, the exemption amount has increased significantly, reaching $12.06 million in 2022. This means that a married couple can transfer $24.12 million free of federal gift or estate tax – and so can their parents.

For example: If a wealthy daughter has a father who is not expected to make use of his entire $12.06 million exclusion amount, the daughter could transfer low-basis assets to the father or to a trust for his benefit that is subject to estate tax. At the father’s death, his estate will not actually owe any estate tax as long as he has enough exemption remaining. However, because the gifted assets are includible in the father’s estate, the income tax basis should be stepped up to the fair market value as of the date of his death.

The upstream transfer can be structured as a gift, as a sale to a carefully drafted trust or as part of a more complex strategy such as a grantor retained annuity trust. At first blush, an observer may wonder why the daughter would use her exemption amount to gift assets upstream to her father, rather than downstream to her children. The answer is that the family expects to receive a step-up in tax basis at the father’s death, which is likely to occur sooner than the daughter’s death. If the assets are highly appreciated, the tax benefit of the upstream gift can be dramatic, particularly if the family had wanted to sell the assets but felt constrained by the built-in capital gain.

It is important to note that the gifted assets will not receive basis step-up if the father dies within one year of the gift and the assets revert back to the daughter at that time. However, many practitioners believe that step-up will be allowed if the assets pass to a trust for the daughter, rather than outright, or if the assets pass to a third party, such as the daughter’s children.

Of course, there are risks that should be considered. The father could happily accept the assets but then decide to pass them on to someone else, such as a new spouse, a friend or another family member whom he believes to be in greater need than the wealthy daughter or her children. Similarly, the father might have creditors who could try to seize the property in satisfaction of their claims.

Both of these risks can be mitigated if the daughter makes the gift to a trust for the father’s benefit, rather than to the father outright. However, the trust agreement would need to contain special provisions designed to trigger estate inclusion – a result that was keenly avoided in the past. Trying to obtain estate inclusion will be a new exercise for many practitioners.

Finally, there is a risk the tax laws will change midstream. Currently, the exemption amount is set to increase incrementally every year until 2026, at which time it is scheduled to revert back to $5 million (plus inflation). However, it is entirely possible that Congress could decide to change the exemption amount before that date. If the exemption amount is unexpectedly reduced after the upstream gift has been made, the older generation may have to pay estate taxes on the gifted assets after all. For this reason, upstream gifts are best suited for clients who have a true desire to provide for their parents, regardless of any tax benefits.

Please contact your BBH wealth planner or relationship manager if you would like to further explore this technique.