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 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 the upstream power of appointment trust.
At its core, this strategy requires someone to include an elderly and much less wealthy relative, such as a parent, as an additional trust beneficiary. But there's much more to it.
Upstream planning involves transferring certain appreciated assets to older or other family members with shorter life expectancies. Because this person will die sooner, a base step-up is triggered sooner when that person dies. So, that person dies, and I obtain a basis step-up on my property, saving me income taxes on depreciation while I own the property (if appropriate) and on 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 taxes. 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.
We all want to save taxes, 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 the 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 it. The IRS rules do not require that he actually know about this power. That said, the 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 that 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 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) or debt securities and the right or option to acquire equity interests, such as stock or debt securities, in the future. At death, the sale of the first asset is 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.
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, originally published in Kiplinger's Personal Finance Magazine, and brought to you by the RJ 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!
This is not tax advice and should not be construed as such. Please seek professional tax services for more information and advice that will apply to your specific tax situation.
The content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual.
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