Tax-Efficient Inter-Generational Transfers: Downstream vs. Upstream Gifting

When the Tax Cuts and Jobs Act (TCJA) took effect in 2018, it effectively doubled the individual lifetime estate tax exemption from $5.5 to $11 million ($22 million for couples filing jointly), substantially reducing the number of Americans subject to the estate tax. Adjusted for inflation, the estate exemption currently stands at $13.6 million for 2024 ($27.2 million for couples). However, many of the provisions of the TJCA (including this larger estate tax exemption) will expire at the end of 2025, unless extended by Congress. Given the political uncertainty, some wealthy households may wish to revisit their estate plans over the next year and consider pulling forward planned bequests to take advantage of the greater lifetime exemption.

Downstream Gifting

40 years ago, the estate tax exemption was only $325,000 per individual, and the portion over that amount was taxed as high as 55%. This motivated wealthy individuals to use trusts to shelter their larger estates from the estate tax. Another common strategy—known as “downstream gifting”—involves elder family members utilizing their annual gift tax exclusion ($10K per beneficiary in 1984—now $18K per beneficiary in 2024) to gift assets tax-free to younger generations, thereby shrinking the taxable estate of the elder family member. These annual gifts are typically made with cash, but they can also involve securities such as stocks, mutual funds, or exchange-traded funds (ETFs). If securities are gifted, the recipient (beneficiary) inherits the same cost basis as the original owner of the shares. Thus, downstream gifts of securities can also be an effective “arbitrage” between applicable tax brackets. For example, a retired couple paying taxes at the highest marginal rate might elect to gift shares of appreciated stock to their grandson, a recent college graduate with an entry-level job, moderate student loan debt, and a much lower marginal tax rate. Assuming the grandson sells the shares and converts them to cash, he may or may not owe capital gains tax on the proceeds (depending on the size of the capital gain relative to his income). Even if he does owe taxes, it will be at a much lower rate than if his grandparents had first liquidated the shares themselves to gift him cash.

Upstream Gifting

This tax rate arbitrage can also work the other way. Imagine a scenario where a very successful middle-aged executive accumulates a large amount of low-cost basis stock through his company’s incentive stock program. This executive’s peak earning years (and highest marginal tax bracket) may overlap with a period when his retired parents of modest means require financial assistance. In this scenario, gifting shares of appreciated stock to his parents—and having them subsequently sell the shares and pay taxes at their own lower tax rate—would be more tax efficient than if the executive were to sell shares himself to provide cash.

Moreover, this form of upstream giving can yield even more tax efficiency thanks to the “stepped-up basis” rule. That is, the IRS permits heirs to “step up” the cost basis of an inherited financial asset to its valuation on the date of death of the person who bequeathed it. Thus, if the middle-aged executive in the example above also happened to be an only child, he might consider gifting his parents some of his highly appreciated company stock (removing it from his estate). His parents could then utilize dividend income from the stock (or sell shares of it as needed) for their financial support during their lifetimes and subsequently bequeath any remaining shares back to their son upon their deaths. At this point, whatever remaining stock the son inherits would have a stepped-up basis, removing his former tax liability. In this way, he can tax-efficiently provide financial support to his parents while also (eventually) eliminating a sizeable future tax liability of his own.

Note that as with all tax and estate planning, the strategies outlined above have caveats and limitations, which may not be appropriate to everyone’s situation. We always recommend consulting with a tax advisor and/or estate planning attorney before implementing your own gifting plan. However, if you are curious about how these strategies might apply to you, please feel free to reach out to your Bristlecone advisor or schedule an appointment with one of our principals by clicking here.

One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past Performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.This content is developed from sources believed to be providing accurate information, and it may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.