- Selling appreciated assets like stock and real estate can trigger high capital gains taxes.
- Moguls can save big by gifting assets to their parents, inheriting them back, and then selling them.
- The ultra-rich can use upstream transfers to double how much their kids inherit without estate tax.
Wealthy entrepreneurs face hefty capital gains taxes if they want to cash out after building a successful business from the ground up.
But if they are willing to wait, they can save big by gifting their stock to their parents and getting it back when they die. Capital gains tax applies to the appreciation between the sale price and the asset’s cost basis, typically its purchase price. “Upstream transfers” take advantage of a tax loophole for inherited assets that boosts the cost basis to its fair market value at the time of inheritance.
For instance, a top earner looking to sell shares that had appreciated by $1 million since they bought them would have to pay about $238,000 in taxes, according to Pam Lucina, chief fiduciary officer at Northern Trust.
But if they give the stock to their parents and sell it after inheriting it, they only have to pay that 23.8% tax rate on how much the stock had appreciated since their parents died, even if the stock had surged in value after they gave it away.
You get the most bang for your buck by choosing assets with a low cost basis relative to their current value. Publicly-held stock, real estate, and private business interests are popular choices, Lucina said.
Upstream planning is a powerful but risky tool, she told Business Insider. Individuals can lose their assets for good if their parents decide to share the wealth with a new spouse or other children. She estimates that only a quarter of clients actually go through with upstream planning after discussing it.
“Once you talk through the risks and the family dynamics aspect of it, it doesn’t work for every family,” she said.
Thanks to tax cuts made during the Trump administration, individuals can gift or bequeath $13.61 million before triggering a 40% federal estate tax. The high exemption threshold has made upstream planning more popular. Lucina expects giving to pick up before the tax cuts expire at the end of 2025, barring action by Congress.
Robert Strauss, partner at estate planning firm Weinstock Manion, typically uses upstream planning with ultra-rich clients who have already used their exemption but have less-wealthy parents who haven’t. They can stash assets in a trust that benefits their parents until their passing and then the children. After the grandparents die, the children inherit the assets with a step-up basis. The federal estate tax doesn’t kick in as long as the grandparents’ estate does not exceed $27.22 million, the exemption for a married couple.
Buyer beware
- The parents’ creditors may have a right ot the assets.
According to Lucina, the parents are usually given power of appointment over the assets to make sure they are included in their taxable estate. This legal right allows the parents to give or transfer the assets while they are alive. It also allows their creditors to pursue the assets, she warned.
- Make sure the whole family is on board.
Lucina said best-laid plans are more likely to fall apart when more people are involved, from siblings to spouses. For instance, the parents might change their minds about leaving a bigger inheritance to one child, even if that child gifted substantial assets to them.
One of Lucina’s clients had to promise to pay the parents’ medical bills in order to get their siblings to agree to the arrangement.
Family dynamics are the thorniest part of upstream planning. Strauss said it is important to be transparent with everyone involved before the upstream transfer.
“You’ve got to navigate the family dynamics to make sure that an upstream actually isn’t going to piss other people off or create an unrealistic expectation in an inheritance that’s not intended,” Strauss said.
- The age of the parents is very important.
While there is no hard and fast rule, Strauss typically uses upstream transfers when the wealth creator’s parents are at least in their seventies or expected to live five more years or less.
It’s a delicate balance. If the parents die within one year of the transfer, the assets do not receive a step up in basis.
However, the assets are tied up during the parents’ lifetime. During that time, the tax law and the value of the assets are bound to fluctuate. It is possible to unintentionally trigger estate taxes if the assets exceed the exemption amount by the time the parents die.
“Ideally, what you’re doing is you’re targeting the exemption amount and not less and not more, but the value of the asset will change and the exemption amount will change,” Strauss said. “It makes it harder to deal with.”
