Take-Away: Much has been written about ‘upstream’ planning, where appreciated assets are gifted to an elderly parent with the purpose of receiving a step-up in the income tax basis of the gifted assets on the death of the parent. Much less has been written about the benefit to ‘downstream’ planning, where assets are transferred to younger generation family members, like children, so that they can further transfer the assets to dynasty trusts using their own federal gift tax exemption of $11.58 million.

Background: With a change in Presidential administrations and a rapidly growing national debt, there is a lot of talk about changing the tax laws to begin to reduce the national debt and to impose higher taxes on the wealthy members of society. In turn, that has initiated a scramble to ‘do something’ before the end of 2020 in anticipation of these tax law changes in 2021.

Upstream planning is based on the assumption that a wealthy donor’s large federal gift tax exemption coupled with their poorer elder parent’s large $11.58 million federal estate tax exemption can be exploited to avoid having to pay capital gains taxes on the donor’s assets.

Downstream planning is premised on the fact that a child does not have enough wealth of their own to comfortably exploit their own $11.58 million federal gift tax exemption while that large gift tax exemption  is still available.

Upstream Planning: Upstream tax planning with gifts has been a hot topic lately, especially after the federal estate tax exemption jumped to over $11 million per individual. A few years back I wrote an article called “Free-basing with Grandma” to explain the tax advantages of these lifetime gifts. If the donee is an elderly parent with little wealth of their own, the gift of appreciated assets to the elderly parent would expose the gifted assets to an income tax basis adjustment, or step-up, on the older parent’s death. [IRC 1014.] The income tax basis of the gifted assets would increase on the parent-owner’s death to their fair market value, but there would presumably be no federal estate tax paid due to the $11.58 million federal estate tax exemption available to the elderly parent’s estate. In short, a tax basis increase would result to avoid future capital gains, but there would be no federal estate tax cost. There are obvious risks associated with this upstream tax planning strategy, e.g. grandma sells the gifted assets; grandma gifts the assets to her late-in-life boyfriend; grandma has creditor problems at the time or her death; or, grandma lives beyond 2025, when her federal estate tax exemption is cut in half. However, the upstream planning has some appeal, particularly if an elderly parent is not expected to live beyond a couple of years.

Downstream Planning: Downstream tax planning is not engaged in to achieve an income tax basis adjustment on death. Rather, downstream planning deals with the reality that a wealthy individual’s child may not have enough wealth for them to use their own $11.58 million federal gift tax exemption before it disappears in 2026 (or even earlier if there is a change in the tax laws to address the growing federal deficit.) The goal of downstream planning is to move assets to the younger generation to enable them to fully exploit their own federal gift tax exemption of $11.58 million while it is remains available to them.

  • Example: Homer and Marge are a highly affluent couple. They have already used their respective $11.58 million in federal gift tax exemptions. They are not prepared to make any more gifts, as those gifts would generate a federal gift tax that would have to be paid by them. Their son, Bart, on the other hand is pretty much a spendthrift, and he does not have much, if any, an estate on his own. While Bart might want to make gifts to a trust for his children (Homer and Marge’s grandchildren) Bart has no assets with which to fund a dynasty trust using his own $11.58 million gift tax exemption. As part of their downstream planning, Homer and Marge loan to Bart $5.0 million in assets using a 20-year promissory note with this month’s currently low AFR interest rate of 1.31%.  The promissory note is interest-only, and the principal balance balloons after 20 years. Bart then uses the same $5.0 million of assets that he have been loaned to him by Homer and Marge to fund a dynasty trust for Bart’s children. Bart now uses part of his federal gift tax exemption, while it is still available, to shelter the $5.0 million he gave to the dynasty trust from federal gift taxes. [ Bart, spendthrift as he is, is more apt to fund a Michigan Qualified Dispositions in Trust, in which he is a potential, future, trust beneficiary of that self-settled dynasty trust.)

Obviously this downstream tax planning strategy should probably only be considered by very wealthy families and only after some of the donee’s circumstances are considered before such a large gift or loan is made. Following the Homer and Marge example, before Homer and Marge make their $5.0 million loan to Bart, they will want to confirm:

  • (i) Commercial Note Terms: Bart will actually follow through with the funding of the dynasty trust for Homer and Marge’s grandchildren. To give the promissory note some economic reality, the note should carry a higher default interest rate obligation, a late payment penalty fee, collateral security, and possibly a note balance acceleration provisions, e.g. Bart’s continue visits to the casino. These arm’s-length commercial loan provisions will cause the note to look like an enforceable note and not a gift (keeping the IRS away), and they will give Bart an actual incentive to timely pay the interest due under the promissory note;
  • (ii) Creditors: Bart does not have any lurking creditors that might seize the gifted assets when in Bart’s possession and used to satisfy Bart’s outstanding debts;
  • (iii) Divorce: Neither Bart, nor his wife, are contemplating a divorce, where the gifted assets might be frozen during the pendency of the divorce action, or diverted by the divorce judge’s division of the marital estate;
  • (iv) Cash flow: Bart has enough assets or income of his own to timely pay the annual interest obligation on the $5.0 million loan, or $65,500 a year. If Bart’s income is not sufficient to service the loan, then the entire loan to him will be highly suspect by the IRS and could treated as a disguised, taxable, gift to Bart from Homer and Marge, since Bart’s ability to service the debt would be illusory;
  • (v) Loan and Gift in Different Amounts: Bart should probably gift an amount to the dynasty trust less than the $5.0 million that Marge and Homer loaned to him in order to avoid the IRS’s claim that the loan to Bart, and funding of the dynasty trust by Bart, are parts of a common scheme, or a step transaction, where the collapse of the steps results in the loan being treated as a taxable gift by Marge and Homer to the dynasty trust for their grandchildren. Bart might also want to fund the trust in 2021, a different year from the year in which the loan is made to him; and
  • (vi) Multiple Gifts: Bart might use some of the funds for beneficiaries who are not the natural objects of Homer and Marge’s bounty. Rather than use the full $5.0 million loan to fund the dynasty trust for Homer and Marge’s grandchildren, perhaps Bart transfers $3.0 million of the loan proceeds to the dynasty trust to benefit his children and more remote descendants, and Bart takes the remaining $2.0 million of the loan proceeds and funds a spousal lifetime access trust (SPLAT) for his wife.

Conclusion: If there is anxiety over how long the very large $11.58 million federal gift tax will be available, for wealthy families they should consider some of the benefits of downstream tax planning to enable their children and grandchildren to make use of their own large federal gift tax exemption.