Oftentimes, advice is given on how to pass assets to younger generations to reduce federal and/or state estate and inheritance taxes. Few strategies consider the younger generation making gifts to the older generation for purposes of overall tax savings. An upward gifting strategy could be a smart play depending on your specific situation.
These are some items that would make an upward gifting strategy worth considering:
- The younger generation created considerable wealth in their lifetime and expects to have a taxable estate.
- The younger generation has highly appreciated assets available to transfer.
- Examples could include farmland, other real estate, marketable securities, closely held business interests, cryptocurrency, etc.
- The older generation does not have a taxable estate and is significantly below the lifetime estate tax exemption amount (also known as the Basic Exclusion Amount (BEA), which is examined later in this article).
- Nontax issues should be considered such as loss of control of assets, creditor issues, marital issues, etc.
If the above applies to your situation, please read further for more details about this upward gifting strategy.
Upward Gifting Strategy
Here is a general framework of the upward gifting strategy:
- The younger generation is expected to have a taxable estate and holds highly appreciated assets that they could gift.
- The younger generation gifts highly appreciated assets to an older generation family member, not to exceed the older generation’s BEA (see BEA section later in this article).
- The older generation updates their estate planning documents to bequest these assets to individuals who are not the original donors (typically children of original donors, but not required to be—see Internal Revenue Code Section 1014(e) Considerations section later in this article).
- At the death of the older generation family member, the assets receive a step-up in tax basis and are distributed to the named beneficiary.
- If executed correctly, the family can potentially reduce both estate tax and income tax.
Basic Exclusion Amount (BEA)
A key part of the upward gifting strategy is that the older generation’s estate value is significantly below the BEA (also referred to as the lifetime estate tax exemption). The BEA for 2023 is $12.92 million per person ($25.84 million for a married couple). This amount represents the cumulative asset value that can be transferred by an individual during their lifetime or at death without being subject to gift or estate tax. The federal gift and estate tax rate is 40% on the value transferred over the BEA. At the current level of the BEA, it is estimated that less than 1% of the U.S. population is subject to gift or estate taxes.
The BEA is indexed annually for inflation but was only temporarily increased for tax years 2018 through 2025. If Congress does not act, the BEA will be significantly reduced in 2026. Therefore, individuals should consider taking action before 2026.
IRC §1014(e) Considerations
An item of high importance to the upward gifting strategy is obtaining a step-up in tax basis for the transferred assets when the older generation family member dies. A step-up in tax basis is generally obtained on assets owned by a decedent at death; however, IRC §1014(e) disallows a step-up in tax basis on assets that were gifted to the decedent within one year of death unless the appreciated property is distributed to someone other than the original donor or their spouse. If this occurs, the assets will not receive a step-up in tax basis.
The two primary ways to avoid IRC §1014(e) and receive a step-up in tax basis through upward gifting are:
- The older generation family member lives beyond one year from the gift date.
- The older generation family member bequests the appreciated asset to someone other than the original donor or their spouse.
Conclusion
The upward gifting strategy may be limited in application but could be a way to reduce both income tax and estate tax. If you are considering this strategy, remember to look at it holistically within the estate plans of both the older and younger generation and consider nontax factors. If you have any questions or need assistance, please reach out to a FORVIS Private Client™ professional or submit the Contact Us form below.