Upstream Gifts to Your Parents. Potentially Significant Income (Estate) Tax Savings

This blog post is about the income tax benefit of you making gifts upwards (or upstream) to your older parents so that the gifted property will be includible in your parents’ estates at their death. This also is especially effective for depreciable property (as I illustrate below).

The key point is the property has to be includible in your parents’ estates for estate tax purposes.  But, here is the beauty of this income tax planning: this stepped-up FMV basis occurs even if your parents pay no estate tax.  Death makes the income tax gain disappear.

As to the income tax stepped-up basis, investment assets like marketable securities and other assets such as art, collectibles, and depreciable property get a new, fresh, FMV stepped-up cost basis.

Stock Shares Example.  Assume you purchased ABC stock shares 15 years ago for $100 per share. The shares are now each worth $1,000. If you sell these shares, you face a $900 gain for income tax purposes on each share. But, if your parents die owning these shares as part of their estate, the recipient as beneficiary of the shares gets to use a new cost-basis equal to the FMV of the shares at the time of your parents’ death. A step-up to the $1,000 FMV as of the date of death.

In this example the recipient turns around and can sell the ABC shares at the new $1,000 FMV cost-basis and face no income tax.  No $900 gain.

Depreciable Property Example.  Here is an even more powerful example with depreciable real estate.

Assume you own an almost fully-depreciated rental building with a FMV of $500,000 (excluding the land value), but with a low adjusted cost-basis of $40,000 due to you having claimed depreciation deductions.  You claimed $460,000 depreciation tax deductions throughout the years.  If you sell the building now, you will trigger a $460,000 income tax gain, with possible ordinary income recapture.

By contrast, the FMV value at death transforms the building’s depreciable cost-basis to its $500,000 FMV, without depreciation recapture.  The beneficiary of the building can, again, begin depreciating the building using its new $500,000 basis.  This produces, effectively, a powerful, double income tax benefit.

Is this simple or complex planning?

This upstream planning can include simple, annual-exclusion gifts, as well as greater complexity, for example, using the remainder gift of a zeroed-out GRAT, etc.  And, for a greater degree of asset protection and added flexibility, the use of an inter-vivos QTIP trust for your parents.

Another possible planning feature, although not essential, is your parents thereafter can allocate GST exemption to the property, using a trust in a way that prevents the property (and any appreciation) from being later includible in your estate.

One forewarning.  Keep Internal Revenue Code Section 1014(e) on your checklist so as to plan purposely to prevent the gifted property from moving back within one year of the gift into your hands at your parents’ deaths.  Such as if a daughter gifts the property to her parents and receives the property back within one year from her parents at their death.

This Section 1014(e) tax law denies the FMV basis step-up for certain one-year situations.  Ideal tax planning is generally always better sooner than later.

BDIT Trusts — “Mamas, don’t let your babies grow up to be tax lawyers.”

This is a tax lawyer, technically-oriented blog post.   It is about a trust known in the trust / tax world as a BDIT (a beneficiary defective inheritor’s trust).  What is a BDIT and as a practical matter when might one use a BDIT?  This “why” touches on income tax advantages and asset protection.

BDIT Example — Assume Anne wants to make gifts to her daughter so her daughter can have a long-term investment nest egg.  Anne also wants to use a trust to provide her daughter with strong asset protection for this gifted property  (against divorce, bankruptcy, personal guarantees, uninsured claims, etc.). Anne wants this trust to be taxed to her daughter at the daughter’s own lower income tax brackets (the daughter no longer falls under the kiddie tax rules).

A BDIT fits this bill.

Anne’s income tax rates are much higher than her daughter’s rates in the above BDIT example, plus Anne is already in the 3.8% Medicare investment tax bracket.  The daughter is not.  Overall Anne saves income and Medicare tax in this BDIT example with her daughter being taxable on the trust’s income and gains.

By contrast, if Anne funds a non-BDIT trust for her daughter, in general either Anne will pay the trust’s income tax at Anne’s own higher income tax rates, or the trust will pay the income tax under its more costly, compressed rate brackets.  This depends on the trust design for Anne.

Now, what about BDIT asset protection?

In this example Anne is funding the BDIT trust for the benefit of her daughter.  This means Anne’s BDIT trust is a “third-party” trust (the third-party is Anne).  This is compared to a trust the daughter creates and funds herself.  If the daughter funds the trust, instead of Anne, the daughter’s trust will be a “self-settled” trust.  That is, self-settled (funded) by the daughter.

Self-settled trusts (compared to third-party trusts) – as general rule – in many cases don’t provide asset protection.  This means the daughter cannot fund her own trust and then try to use the trust as a shield for asset protection purposes.  Whereas, the daughter is in a much better position to use Anne’s third-party funded BDIT trust as an asset protection shield.

I don’t discuss in this post how to design a BDIT.

But, with BDITs being relatively new in the trust world, and as with any trust subject to various trust, asset protection, lapsing withdrawal right, and tax laws, there is a vast array of differing views on how best to design the BDIT.

I enjoy digging into the nuances of how to optimize this BDIT planning.  And this is an example of a highly technical thicket of complexity that, throughout the years, makes me recall the old Willie Nelson tune, which I often sing under my breath with the lyrics slightly changed to “Mamas, don’t let your babies grow up to be tax lawyers.”

Canada – We Are On Our Way. An Income Tax-Based Estate System

This is a point I harp on frequently, most recently in my June 18, 2015 blog post.   Click here for my earlier post,   That is, if you are married make sure your core estate planning documents include a QTIP marital trust and a QTIPable by-pass trust for your surviving spouse.  Do not use the well-worn credit shelter trust.

My primary point is for you to read the related income tax provisions in the 300-page February 2015 “General Explanation of the Administration’s Fiscal Year 2016 Revenue Proposals” (click here to see it).  The specific proposal I address is on page 156.  It, in my view, gives us yet another writing-on-the-wall that the bulk of us will at some point face an income tax at death on our date-of-death accrued gains rather than paying an estate tax.  In other words, we will face an estate situation in large part similar to the income tax / estate system in Canada.

This is writing-on-the-wall, as I do not see this proposal being implemented in the immediately foreseeable future.  But, it is coming.

For example, assume a person owns 1,000 shares of Apple stock at death with a cost basis of $50 per share. The Apple stock is now worth $120 per share on the date of the person’s death.  In this example that person’s estate will pay income tax on the $70 capital gain rather than an estate tax [the $70 per share gain is the $120 per share current value less the $50 cost basis].  Keep in mind this is income tax on the gain even if the estate does not sell the stock.

There also is an important exception in this 2016 income tax-gain revenue proposal. This income tax gain requirement will not apply at the death of a spouse to the extent the property passes to the surviving spouse (or to a charity).

This means the best and most flexible degree of foresight for your core estate planning is to include a QTIP marital trust and a QTIPable by-pass trust that most likely will be treated favorably under this surviving spouse exception.   I am willing to bet the farm that the tried-and-true credit shelter trust will not fall within this exception.

From a planning perspective I also see no downside to the use of the QTIP trust approach, even if I end up wrong about this move toward Canada.







The QTIPable By-Pass Trust; A Crystal-Ball Perspective

Estate planning documents that include built-in flexibility enabling an opt-in / opt-out approach to future changes in the law or circumstances are products of excellent work. The drafter needs to keep a crystal-ball perspective as to what might reasonably occur in the client’s future in order to move in the direction of this kind of excellent work. On the other hand, it is much easier to prepare an average, static, mediocre document.

There are dozens of reasons to maintain this crystal-ball perspective, and here is simply one important example:

As a broad proposition, I find no reason for using the old “By-Pass Trust” design for a married couple’s estate planning. This is the garden-variety “By-Pass Trust” that has been part of a married couple’s A-B trust estate plan for the past 30-plus years.

Rather, I prefer a QTIPable By-Pass Trust that provides essential income tax planning options not available with the above old By-Pass Trust design.

Why this importance of income tax options?

Because I am convinced our estate tax regime is continuing to move in the direction of the Canadian system where property gains will be taxed at death for income tax purposes, regardless of whether a person is over or under the threshold for estate tax. The QTIP trust likely will provide an optimal, effective response to reducing this income tax exposure.

As an example of these income tax headwinds we face, the federal government’s February 2015 “General Explanation of the Administration’s Fiscal Year 2016 Revenue Proposals” includes dozens of possible changes in the income tax law at death for certain taxable “deemed realization” events. Click here to see these 2016 revenue proposals.

Some practitioners by personality are simply not comfortable with the notion of change. Some also will continue to argue for the old-style By-Pass Trust as being necessary so that the surviving spouse’s children and descendants are included with the surviving spouse as beneficiaries of the trust. But, as an important aside, my 20+ years of lawyering make me conclude most children and descendants try and overreach whatever is available to them from the By-Pass Trust, especially when their mother is the surviving spouse. To the contrary, I prefer that the surviving spouse possess the utmost in independence and financial autonomy without this kind of overreaching.

But, again, my predominant objection to this 30-year old By-Pass Trust approach is that it simply does not provide income tax planning options.

Income Tax (estate) Planning with the Delaware Tax Trap

Click here for my newsletter.  This is my recent March 30 newsletter that illustrates the increasing importance of income tax planning as part of estate planning.  Although this newsletter is directed at tax practitioners already familiar with the Delaware Tax Trap, my newsletter also includes an excellent primer on the Delaware Tax Trap.

There are Various Types of Defective Trust Rules

This short blog post follows by March 2, 2015 post and is for those readers who desire a bit more technical discussion. Therefore, keep in mind the tax law and trust rules for creating a defective trust for income tax purposes relative to the person who creates the trust (such as being defective as to the settlor [creator] of the trust) are different than a defective trust for income tax purposes relative to a beneficiary.

There are also design distinctions where the trust is either:

  • defective for income tax purposes but not includible later for estate tax purposes [with this design Jane in my previous March 2 post would not get a stepped-up basis for the credit-shelter trust assets at her later death]; or
  • defective for income tax purposes and also later includible for estate tax purposes [this is the example in my March 2 post for Jane), or
  • not defective for income tax purposes, but later includible in the estate [this is, for example, a DING trust for income tax purposes where the trust is purposely designed to be subject to state tax jurisdictions in a targeted state with no income tax].

$1 Million Income Tax Savings for a $4 Million Credit-Shelter Trust

This modest illustration demonstrates how the typical credit-shelter trust can be very costly to a large number of married couples if the trust is not purposely designed as a defective trust for income tax purposes.  Income tax planning now is a mandate for estate planning.

In this example, a $4 million beneficiary defective credit-shelter trust during the surviving spouse’s 20-year remaining lifetime saves approximately $1 million of income tax.

This income tax savings over the surviving spouse’s 20-year lifetime (in this example) has two components:

$541,000 in income tax savings. This is 20 years of avoiding the more compressed top marginal income and capital gain tax rates for trusts, including the 3.8% Medicare investment tax; and

$357,200 in income tax savings. This is at the end of the 20-years getting a second stepped-up cost basis for the credit-shelter trust assets at the surviving spouse‘s death.

This John / Jane Credit-Shelter Trust Example

John Smith dies at age 77 with $4.0 million of his own property. His wife Jane, age 68, has $1.5 million of her own property, plus social security and a modest source of her own income. Jane is in excellent health and expected to live at least 20 years following John’s death. She would like ideally to preserve the credit-shelter trust for the children and grandchildren.

John’s $4.0 million estate passes into his credit-shelter trust for Jane’s benefit. This credit-shelter trust is designed purposely as a beneficiary defective trust as to Jane during her remaining lifetime.

Assume the $4.0 million credit-shelter trust produces a $320,000 annual return of 8%, consisting of $256,000 capital gains and $64,000 ordinary interest income [roughly an 80 / 20 asset allocation].

Income Tax Illustration 1:  A Non-Defective Credit-Shelter Trust

The annual $64,000 ordinary interest income and $256,000 capital gains for a non-defective credit-shelter trust produce the largest amount of annual income tax: $86,478. This each year includes $11,695 of 3.8% Medicare investment tax. The ordinary income and capital gains are taxed at the credit-shelter trust tax rates. [Computed using 2013 rates.]

Income Tax Illustration 2:  A Beneficiary Defective Credit-Shelter Trust 

By contrast, this beneficiary defective credit-shelter trust results in the interest income and capital gains being taxed at Jane’s own personal income tax rates, including her less-costly threshold for the 3.8% Medicare tax. The higher marginal trust rates do not apply.

This defective trust status reduces the annual tax to $59,405 (compared to the $86,478 trust income tax above). This defective status saves Jane $27,073 in income tax each year [$59,405 annually compared to the more costly $86,478].

This annual income tax savings includes $7,135 less each year for the 3.8% Medicare tax compared to the above non-defective trust approach.

This annual income tax savings over Jane’s 20-years will enhance the credit-shelter trust value by $541,460 [20 times $27,073].

Additional Income Tax Saving for a Second Stepped-Up Basis

For a typical credit-shelter trust there is no stepped-up basis for the trust assets when the surviving spouse dies.  But, by contrast, it is this purposeful beneficiary defective trust design in this example that results in John’s credit-shelter trust assets getting a second stepped-up basis at Jane’s subsequent death. This is an additional level of income tax savings.  [The first stepped-up basis was at John’s death.]

Assume, for example, the market growth of the $4.0 million credit-shelter trust assets during the 20 years following John’s death increases 2% each year (in addition to the above annual 8% return). This results in a compounded increase in the trust assets from $4.0 million to approximately $5.9 million. This $1.9 million increase is the unrealized gain growth during the 20-year period at Jane’s death.

At Jane’s death this $1.9 million growth will get the benefit of a stepped-up basis. Thus, no taxable gain to the children. This saves an additional $357,200 of capital gains tax [18.8% tax rate times $1.9 million; using a 15% capital gains rate plus the 3.8% Medicare tax].

Family Business in a Trust; the 3.8% Medicare Investment Tax

Here is the situation for this blog post. John Doe dies. John was the patriarch of his family’s 40-year operating business. John worked full-time, actively in the business.   The business operates as a pass-through LLC entity for tax reporting purposes. While John was alive the LLC’s net income was not subject to the 3.8% Medicare investment tax.   This is because John actively participated in the business.

Now, this example takes a different turn:

At John Doe’s death he leaves the family business to his wife Jane. John’s two adult sons work full-time in the family business.   Jane does not work in the business.

Following John’s death the 3.8% investment tax will now likely apply to the LLC’s net income. This can be a financial surprise to this Doe family where there was no 3.8% investment tax while John was alive, but the costly 3.8% tax surfaces after John’s death.

This example brings up three important points:

One. This 3.8% investment tax planning should be on the front-burner of your estate planner’s To-Do list in view of the early 2014 U.S. Tax Court opinion in Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (3/27/14).  Click here for a copy of this opinion.

[Keep in mind this Aragona case deals with whether business losses in a trust situation are passive activity losses that have to be suspended for later tax return recognition.  But, the relevance of Aragona to the 3.8% investment tax is the similar question of whether the ownership of a business is a passive activity triggering the 3.8% tax.]

Two. There are planning opportunities that can help avoid this 3.8% investment tax. This gets into the purposeful design of a surviving spouse trust for Jane that will hold the family business interest after John’s death, and the related design of the trustee designations.

Three. This is one of dozens of examples where income tax planning must now be a priority for one’s estate planning.

Estate / Income Tax Planning with the Stepped-Up Cost Basis. Part 1 of 3.

This is 1 of 3 blog posts on this subject of stepped-up cost basis.

Congress in early 2013 essentially converted our federal estate tax system into an income tax system.   For most people not in the wealthiest top 1%, they will face at death greater income tax exposure, with the corresponding benefit of paying no estate tax. The top 1% will likely pay estate tax.

Here is a question this 99% group needs to ask their advisors: “Does my estate planning include income tax savings features?”  If not, your planning misses the mark, in my opinion.

One highly beneficial income tax-savings feature for estate planning is to build-in flexible options for maximizing the stepped-up cost basis when each spouse dies. This flexibility ideally also must give the surviving spouse, at the time of the first spouse’s death, the ability to opt-out of this income tax planning.


This income tax savings is beneficial only if the married couple will pay no estate tax. Essentially, it can produce significant income tax savings as long as the married couple remains in the no-estate tax 99% group. More pointedly, this stepped-up basis is crucial in reducing the taxable gain for income tax purposes when the after-death property is sold, including, very powerfully, property that has been depreciated.

This next point is important.

This stepped-cost cost basis treatment for income tax purposes has different results if you receive, for example, property from John Doe as a gift versus receiving property from John Doe when John dies. Death transfers under the tax law are better for reducing the income tax on this gain situation. Gift transfers typically do not produce this income tax savings. I will illustrate these two concepts in my next blog post.