Upstream Basis Planning: How to Use Your Estate Plan to Save Tax

Upstream Basis Planning: How to Use Your Estate Plan to Save Tax

By John M. Goralka
Sacramento, CA

First, this article is not about fishing! This article is about using your estate plan to reduce capital gains or income tax.

A very few definitions:

Basis:

The amount that you reduce the price of an asset to determine the taxable gain. Often, this amount will be your historical cost (that may be adjusted for depreciation or other items for the accountants that may be reading).

Step-up (in basis):

If I sold you my home for $400,000 (a fixer upper) and I paid $100,000 for that home, 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 (8) 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.”

Lifetime estate tax exemption:

The lifetime estate and gift tax exemption is presently $12.06 million per person. For a married couple, that is $25.12, million which represents that 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 January 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 $25.12 million estate gift tax exemption dropped by about $12 million for a married couple. The gift tax exemption is a use it or lose it alternative. 

Upstream planning involves transferring certain attributes to appreciated assets to older or other family members with a shorter life expectancy. 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 income tax.

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 we 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 providing the basis step-up and the income tax savings.

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 Uncle Joe 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. 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.

What can we do with such a planning tool? Imagine holding two (2) assets. The first asset with a zero basis and a 10-million-dollar fair market value. The second asset has a fair market value of $1 and a basis of $10 million. 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 that may be related to Uncle Joe.

John Goralka is the lead attorney and founder of the Goralka Law Firm, P.C., and is an experienced Sacramento estate planning and tax planning lawyer.

For help in Sacramento with estate planning or tax planning, please contact our office.