This Trust Strategy Can Reduce Your Taxes Big-Time

Upstream basis planning can help younger wealthy people pay less taxes on highly appreciated assets if they appoint an aging relative as a trust beneficiary.

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Editor’s note: This is part 12 of an ongoing series about using trusts and LLCs in estate planning, asset protection and tax planning. The effectiveness of these powerful tools — especially for asset protection and tax planning — depends very much on how they are configured to work together and whether certain types of control over assets and property are surrendered by the property owner. See below for links to the other articles in the series.

Upstream basis planning is a strategy that involves gifting assets to someone who’s going to pass away before you in order to reduce capital gains taxes. This technique is reliant on the rule that to get a step-up in basis, assets must be included in the gross estate of a person who dies.

Put differently, during the lifetime of a trust maker, whether the value of a trust’s assets goes up or down, a trust (neither a revocable trust nor an incomplete gift irrevocable trust) will not reduce or diminish the capital gains tax consequences when the trust maker sells the assets. If the trust assets have a lower basis than the fair market value, once the trust sells or disposes of the assets by certain transfers, either the trust or the trust maker will need to recognize the capital gain (with the gain basically calculated as the sale price minus the basis) and pay capital gains taxes on the gain. (If the value of the trust assets go down in value, the trust maker or your trust may want to recognize the capital loss.)

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However, if a younger person chooses an older relative, such as an aging parent, as a trust beneficiary, when that older person dies, the assets in the trust will receive the step-up in basis and potentially return to the ownership of the younger person at the higher value.

Here’s how it could work

Example. A parent’s adult offspring has land worth $5 million and a basis of $500,000. In 2020, the child makes a completed gift of the land to an asset protection trust with their aging parent as beneficiary, using $5 million of the child’s lifetime exemption from gift and estate taxes. The child ensures that the entire value of the land will be included in the parent’s gross estate by also giving the parent a testamentary general power of appointment, which permits the parent upon their death to leave the land to anyone whom the parent wishes, including the parent’s creditors. The parent dies in 2024 when the land has doubled in value to $10 million. Happily, the parent exercised the power of appointment in favor of the child, giving the land back to the gifting child. More fortunately, the parent has adequate estate tax exemption so that even though the land is included in the parent’s gross estate, the land is not subject to estate tax. The best result is that because the land was included in the parent’s gross estate, the child gets the land back with a step-up in basis to the time-of-death fair market value of $10 million.

How everything is set up is critical

Yes, you read that right — upstream gifts from the younger generation to the older generation create intergenerational basis step-up opportunities. However, the assets gifted from the younger to the older generations must be included in the gross estate of the older generation — potentially taxable.

Additionally, the assets must be directed via a power of appointment at the discretion of the older generation. Because of the potential for estate tax by the older generation, as well as the granted power to appoint trust assets to beneficiaries, this planning technique must be carefully considered.

My next article will be about using LLCs to protect against liabilities originating from LLC-owned assets.

Other Articles in This Series

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Rustin Diehl, JD, LLM
Rustin Diehl, JD, LLM
Attorney and Counselor at Law, Allegis Law

Rustin Diehl advises clients on tax, business and estate planning matters. Rustin serves as an adjunct professor, frequent speaker and is current or former chair of professional associations. Rustin is a prolific author and has published many technical and popular articles on estate and business issues, as well as drafting and advising legislators in developing numerous statutes pertaining to trust and estate and business planning, creditor exemption planning and digital asset (blockchain) trusts and blockchain entities known as decentralized autonomous organizations.

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