In March of 2023, the IRS issued an advance version of Revenue Ruling 2023-2. The heart of the ruling is the situation-specific removal of a step-up in basis for assets held in an irrevocable grantor trust that is NOT included in the deceased grantor’s gross estate for federal tax purposes.
Defining Irrevocable Trusts
An irrevocable trust has a grantor, a trustee and a beneficiary. When the grantor places an asset into an irrevocable trust, it is considered a gift to the trust, and the grantor cannot control or change the assets without the permission of the beneficiary. Such trusts serve to remove certain assets from a grantor’s taxable estate as a means of shielding against potential creditors or lawsuits, minimizing estate tax burdens, and aiding in qualifying for certain government benefits such as long term care under Medicare.
The Impact of Revenue Ruling 2023-2
Prior to R.R. 2023-2, transfers from the trust at death typically received a step-up in basis without IRS challenge. But that may not be the case any longer. The new ruling states that property held in an irrevocable trust that is not included in the taxable estate at death will not receive a step-up in basis.
In short, beneficiaries will not inherit such assets with a new basis at their current fair market value (FMV). Rather, they will be subject to capital gains against the difference between original cost/basis and ultimate sales value. This means that an asset that originally cost $100K and was transferred at FMV of $1M (FMV at time of death) would be subject to capital gains on the incremental $900K (versus zero capital gains prior to the change).
Section 1014 of the Internal Revenue Code generally provides that the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent, if not sold, exchanged, or otherwise disposed of before the decedent’s death by that person, is the fair market value of the property at the date of the decedent’s death.
With Rev. Rul. 2023-2, the IRS has determined that the basis “step-up” under section 1014 does not apply to assets gifted to an irrevocable grantor trust by completed gift in cases in which such assets are not included in the gross estate of the owner of the trust for federal estate tax purposes.
In such cases, even though the grantor trust’s owner is liable for federal income tax on the trust’s income, the assets of the grantor trust are not considered as acquired or passed from a decedent by bequest, devise, inheritance, or otherwise within the meaning of section 1014(b), and therefore section 1014(a) does not apply.
Moving Forward Under Revenue Ruling 2023-2
Reactions have been mixed, but taxpayers with an irrevocable trust would be well served by an immediate review of their personal/estate planning circumstances with their preferred financial advisor(s). Moving beyond the immediate implications of this particular tax position change, it is likely that further “revenue-enhancing” changes will be forthcoming from the IRS as attempts are made to garner additional revenues to fund the ever-growing federal budget.
Advisors should reach out to their clients with irrevocable trust for possible remedies to this material change, and both advisors and clients must be diligent in identifying and reacting to these changes as they unfold.
