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On March 30, 2023, the Internal Revenue Service issued Revenue Ruling 2023-2. The essence of this brief ruling is that completed gifts to an irrevocable grantor trust do not receive a “step-up” in basis upon the death of the grantor. The ruling has the potential to cause tax consequences for beneficiaries of a variety of irrevocable trusts. In this blog post, we’ll discuss the meaning of the new IRS ruling on irrevocable trusts, what types of irrevocable trusts are affected, and what you may be able to do to minimize taxes in light of Ruling 2023-2.
What is a Step-Up in Basis?
Under Internal Revenue Code Section 1014, assets received from a deceased person (decedent) upon the decedent’s death are given a step-up in basis. The basis of an item is the cost of acquiring it plus certain other costs associated with the item, such as transaction fees or improvements.
When an asset is sold, the seller may pay capital gains tax on the gains from the sale. The amount of the tax is based on the amount of gain: the sale price, less the basis of the item. For instance, if you owned stocks with a basis of $10,000 and you sold them for $100,000, your taxable gain would be $90,000.
However, if you left those same stocks to your child in your will, your child would take a step-up in basis to the market price of the stock as of the date of your death. If the stocks had appreciated to $100,000 as of your death, that would be your child’s basis. If she then immediately sold the stocks, she would likely have very little capital gains on which to pay tax.
Under the new IRS ruling, if you had placed the stocks in certain types of irrevocable trusts, there would be no step-up in basis at your death. If the trust sold the stock, capital gains would be calculated based on your original basis of $10,000.
Why Don’t Irrevocable Grantor Trusts Get a Step-Up in Basis?
Assets that get a step-up in basis on an owner’s death are generally those that would be included in the decedent’s taxable estate. Completed gifts of assets to certain types of irrevocable trusts are removed from the grantor’s taxable estate, but income on the assets is reported on the grantor’s tax return during the grantor’s lifetime. The new IRS ruling confirms that even though the assets in irrevocable grantor trusts are income taxable to the grantor, that’s not enough to qualify them for the step-up in basis loophole. In short, if the assets were transferred away from the grantor’s ownership during his or her lifetime, there is no step-up in basis.
What Trusts Does the New IRS Ruling on Irrevocable Trusts Apply To?
There are many types of trusts, and the new IRS ruling does not apply to all of them. For instance, many people have revocable living trusts that become irrevocable upon their deaths. However, during their life they can remove assets from the trust or revoke the trust altogether. These trusts ARE NOT subject to the new IRS rulings.
The trusts affected by the new IRS ruling are sometimes referred to as “intentionally defective grantor trusts (IDGTs).” A grantor trust is a separate legal entity from the grantor (person who created and funded the trust), but the grantor is considered the owner of trust assets for income tax purposes. As discussed above, the grantor cannot reclaim the trust assets as his or her own because the trust is irrevocable and the grantor cannot change its terms.
Intentionally defective grantor trusts affected by the new IRS ruling on irrevocable trusts include qualified personal residence trusts (QPRTs), grantor-retained annuity trusts (GRATs), insurance trusts, spousal lifetime access trusts (SLATs), and others. If you are still determining whether your trust is affected by the new IRS ruling, consult your estate planning attorney.
What are Some Planning Options for Grantors of Trusts Affected by the New IRS Ruling?
If you are the grantor of a trust affected by Revenue Ruling 2023-2, there are some strategies your estate planning attorney may employ to reduce capital gains.
Substitution of Assets
While a grantor cannot remove assets from an irrevocable grantor trust, the terms of the trust may permit him or her to exchange assets in the trust for other property of equivalent value. If such a substitution power exists in your trust, you could potentially exchange non-trust property that has a high basis for an equivalent amount of trust assets that have a lower basis. Upon your death, those lower-basis assets exchanged out of the trust would be considered part of your taxable estate and receive a step-up in value.
Second Sale of Assets to Trust
Not all trusts have a power of substitution, but an alternative may be for the grantor to purchase assets with a low basis from the trust with high-basis assets. This may sound like a substitution of assets, but it’s a bit different.
In the so-called “first sale,” the grantor creates the trust and sells assets to it in exchange for a promissory note; the trust then pays the grantor back over time, usually with interest. In the “second sale,” the grantor sells additional assets (with a high basis) to the trust, and is paid in the low-basis assets originally sold to the trust.
Power of Appointment
Under some circumstances, the grantor of a trust may be able to give a testamentary general power of appointment over a trust to another person (such as an elderly parent) who is likely to predecease the grantor. The person to whom a power of appointment is granted is called the “powerholder.”
Assets subject to a power of appointment are included in the taxable estate of the powerholder. Accordingly, on that person’s death, those assets are eligible for the Section 1014 step-up in basis. There are limitations on this option; for instance, the amount of assets over which a power of appointment is given should not be greater than the powerholder’s available estate tax exemption. This strategy, like those above, requires the guidance of an experienced estate planning attorney with a background in tax planning.
Strategies to avoid capital gains tax in light of the new IRS ruling on irrevocable trusts are complex. If you are concerned about your exposure to taxation in light of the new IRS rulings, contact Estate Planning & Elder Law Services to schedule a consultation.
