IRS: Assets conveyed to an irrevocable grantor trust are not eligible for step-up in basis

Step-Up in Basis.

Generally, assets that are part of a person’s gross estate for estate tax purposes receive a step-up in tax basis at the time of the owner’s death, pursuant to Internal Revenue Code Section 1014. The higher basis reduces the taxable gain on the asset when it is sold.

Example:

In 1990, Michael bought a Babe Ruth baseball card for $100,000. By early 2020, its value had grown to $400,000. If he had sold it then, he would have owed taxes on the $300,000 gain in the card’s value.

However, he kept the card and left it to his son, Dennis, pursuant to Michael’s will or revocable trust. When Michael died in late 2020, Dennis inherited the card, and its tax basis was “stepped up” to its appraised value of $400,000.

Dennis sold the card later that year for $450,000 and was taxed only on the $50,000 by which the card appreciated after his dad’s death.

Revenue Ruling Impact.

When the creator (or “grantor”) of an

irrevocable grantor

trust conveys a personal asset into the trust, that asset ceases to be part of the grantor’s estate. (Reducing the taxable value of one’s estate is a common objective in creating an irrevocable trust.) By the time a trust asset reaches a beneficiary of the trust, two transfers have occurred: (1) from the grantor to the trust, and (2) from the trust to the beneficiary. Therefore, there is no direct transfer of ownership from the grantor to the beneficiary, as the trust served as an intermediate owner.

Beneficiaries who received assets from an irrevocable trust commonly try to claim a step-up in basis concurrent with the grantor’s death. The resulting reduction in the beneficiary’s tax burden, and the government’s loss of tax revenue, triggered the issuance of IRS Revenue Ruling 2023-2, which boils down to this:

Assets held by an irrevocable grantor trust do not receive a step-up in basis at the death of the grantor.

1

That is a big deal, which we can illustrate by applying it to the Babe Ruth card.

In this scenario, Michael created an irrevocable grantor trust, named Dennis as a beneficiary, and transferred the Babe Ruth card to the trust.

When Michael died, the trust transferred the card to Dennis, who, as in the previous example, eventually sold it for $450,000. So far, so good, except for one important consequence: Because the card was, for a time, the property of Michael’s irrevocable trust, there was no direct conveyance of the card from Michael to Dennis and, thanks to the revenue ruling, there is no step-up in tax basis.

Instead of paying tax only on the $50,000 increase in value that occurred during his ownership, Dennis was taxed on a whopping $350,000 (the difference between the $450,000 selling price and the $100,000 that his dad originally paid for the card).

Strategies.

This ruling directly impacts a variety of irrevocable trusts, including grantor retained annuity trusts, qualified personal residence trusts, insurance trusts, and other grantor trusts.

Following are a few strategies that could benefit clients who have incorporated irrevocable trusts into their estate planning and want to retain the step-up in basis upon their death.

1. 
   

   Many irrevocable grantor trusts have a provision that allows the grantor to substitute or exchange personal assets for assets of equal value owned by the trust. This provision, known as a “power of substitution,” would allow you (the grantor) to substitute an asset that

   
   
   
   

   you

   
   
   
   

   own for an asset that the

   
   
   
   

   trust

   
   
   

   owns and that is of equal value but has a lower basis. By doing so, the asset with the lower basis is now part of your estate at your death and receives a step-up to fair market value. The asset that the trust owns does not receive the step-up, but it already had a higher basis when it was transferred.

2. If the trust does not contain a power of substitution, you (still the grantor) could purchase low-basis assets from the trust in exchange for high-basis assets, such as cash for stock. For example, if the trust owns stock that is worth $1 million but has a basis of $500,000, you could pay the trust $1 million in cash and purchase the stock. The stock is part of your estate when you die, and it receives the step-up in basis. You have still moved $1 million out of your estate for estate tax purposes by paying that amount to the trust. This strategy ensures that low-basis assets continue to cycle back to you, enabling the estate to take full advantage of the step-up at your death.

3. 
   

   The final alternative involves granting to a third party a testamentary “general power of appointment” over the irrevocable trust. Essentially, the power of appointment (a) gives the “power holder” the ability to direct who receives the trust’s assets and (b) causes those assets to be included in the

   
   
   

   power holder’s

   
   
   

   estate for estate tax purposes. As a result, the assets get a step-up in basis upon the power holder’s death. In this instance, you want to be sure that the power holder has enough estate tax exemption that including the trust’s assets in their estate does not result in an estate tax.

   
   
   
   
   

Conclusion.

As

Investopedia

states, irrevocable trusts are “generally set up to minimize estate taxes, access government benefits, and protect assets. This is in contrast to a revocable trust, which allows the grantor to modify the trust, but loses certain benefits such as creditor protection.”

The non-tax benefits of an irrevocable trust will continue to justify its use in many situations, but there is no denying that IRS Revenue Ruling 2023-2 complicates its inclusion in many planning scenarios.

If your estate plan includes any type of irrevocable trust, you should contact your trust attorney for an analysis of whether, and to what extent, a plan revision would benefit you and your beneficiaries.

1

You may wonder why the beneficiary of an irrevocable grantor trust would try to claim a step-up in basis applies to the trust’s assets. The reason has to do with the term “grantor.” When an irrevocable trust is a grantor trust, it means that the creator of the trust – the grantor  ̶  is still responsible for the income taxes generated by the trust’s assets, even though the grantor no longer owns those assets. For example, let’s say I transfer stocks worth $100,000 to an irrevocable grantor trust and name my children as the beneficiaries of that trust. Those stocks generate dividend income that is retained by the trust. Because the trust is a grantor trust for income tax purposes, I am responsible for paying the income tax due on those dividends, even though the trust retains the dividend income for my children’s benefit (which, by the way, also allows me to essentially make additional tax-free gifts to my children, since the trust value is not reduced by the payment of those taxes). The argument is that, since the stocks are still part of my estate for at least the purpose of paying income taxes, they should receive a step-up in basis at my death. The IRS argues that, since those stocks are not part of my estate for estate tax purposes, no step-up applies.