Can Upstream Gifting Help Reduce Estate Taxes?

I've been making yearly gifts to our kids and grandkids, but I'm still worried my estate could face taxes if the federal estate and gift tax exemption is cut in half next year. Given the uncertainty, however, I'm leery of locking up assets in a trust. Is there another strategy I could use to help reduce estate taxes?

The potential reduction in the estate and gift tax exemption is an important and timely topic.

The Tax Cuts and Jobs Act of 2017 temporarily increased the lifetime exemption, which in 2025 is $13.99 million per individual. If Congress doesn't extend the law, it will expire at the end of the year and the exemption will be cut roughly in half on January 1, 2026. Estates over that amount may be taxed up to 40%.

It's great you're thinking about this now, because if the tax exemption is halved, we probably won't know until it's too late to do much about it. Barring the creation of a trust, you'll likely need a more creative strategy—such as upstream gifting.

Most estate plans flow downstream, with assets passing from older folks to younger ones. Upstream gifting takes a less direct route by transferring assets to older generations—such as parents or even grandparents—who can benefit from them during their lifetimes before leaving them to the original owner's children or other beneficiaries.

This strategy could make sense for individuals who own assets with high appreciation potential or that throw off a lot of income—both of which could add to their taxable estate and push them over a present or future estate tax limit.

Let's say Melanie, a 55-year-old tech pioneer, has $8 million in appreciated stock from her employer, plus real estate and other assets totaling $4 million. She's divorced and has one son; her father is deceased, and her mother has chronic health issues that require an ever-increasing share of her fixed income.

Using an upstream gifting strategy, Melanie transfers $5 million of her company stock to her mother. Because Melanie gives the gift during her lifetime, the shares retain their original cost basis of $2 million. Once the transfer is complete, Melanie's mother modifies her estate plan to pass the stock to Melanie's son upon her death—in the meantime receiving some $75,000 in annual dividend payments.

Let's assume the stock is worth $6.5 million when Melanie's mother dies. Under current tax law, the assets would pass to Melanie's son entirely tax-free at the federal level (although he may owe state-level inheritance tax if he resides in Kentucky, Maryland, Nebraska, New Jersey, or Pennsylvania).

The $5 million would still count toward Melanie's estate and gift tax exemption, but by upstream gifting, she was able to:

• Reduce her taxable estate by $5 million.
• Shift any future appreciation outside her estate.
• Provide additional income for her mother and establish an early inheritance for her son.
• Reset the stock's cost basis during her lifetime. (Had she gifted the stock to her son outright, he would have inherited its original cost basis of $2 million, as opposed to its value of $6.5 million at the time of his grandmother's death, and potentially owed tax on the gains.)

For upstream gifting to be effective, the older recipient of your gift should have an estate much smaller than the current or future gift and estate tax exemption—accounting not just for today's value but also any appreciation potential.

For example, had Melanie's gift put her mother's estate over the current or future lifetime estate and gift tax exemption, it could have undercut the efficacy of this strategy. Also bear in mind:

• Family dynamics: Despite your intentions, a gift is a gift, and the recipient has every right to do whatever they wish with it. In a worst-case scenario, the recipient could decide not to transfer the assets to your intended heirs.
• Risk exposure: Assets owned by the recipient become subject to the claims of their creditors, which could reduce the ultimate beneficiary's share of the gift.
• Income taxes: Earnings generated by gifted assets can affect the recipient's income taxes, Medicare premiums, and eligibility for government benefits. Consult a qualified tax advisor to determine how a gift could affect the recipient's overall finances.

As with all estate-planning moves, discuss your situation and goals with an estate attorney or a tax advisor before making any major changes.