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No Basis Adjustments for Assets in Irrevocable Grantor Trusts

Revenue Ruling 2023-2 confirms that taxpayers can’t have their cake and eat it too.

A recent Internal Revenue Service revenue ruling has finally settled the debate over whether the assets in an irrevocable grantor trust can get a step-up in basis at the grantor’s death. Revenue Ruling 2023-2 makes clear that there’s no step-up in basis.

For years, practitioners have anticipated guidance from the IRS as to whether assets held in an irrevocable grantor trust that were removed from the grantor’s estate for federal estate tax purposes, but which remained taxable to the grantor for income tax purposes under Internal Revenue Code Sections 671-679, could receive a step-up in basis on the grantor's death. Some commonly refer to such trusts as “grantor trusts,” “intentionally defective grantor trusts” or “IDGTs.” These trusts are popular, in part, as an “estate tax freeze” because such trusts can remove the appreciation on assets held by the trust that occurs after the assets are gifted or acquired by the trust from federal estate taxation at the grantor’s death.

An additional reduction in the size of the grantor’s estate also results from the “tax burn” associated with the grantor’s obligation to personally report and be responsible for income tax consequences of such a trust. That’s because the grantor’s payment of the income tax isn’t treated as an additional gift.

Differing Views

Some have argued that IRC Section 1014(a) provides an additional benefit in the form of a step-up in basis on assets of the trust at the grantor’s death. (Jonathan G. Blattmachr, Mitchell M. Gans, and Hugh H. Jacobson, "Income Tax Effects of Termination of Grantor Trust Status by Reason of the Grantor's Death," 97 J. Tax'n 149 (2002).)

Many other planners believed a step-up in basis generally wasn’t possible if the assets weren’t included in the grantor’s estate for federal estate tax purposes. To address the income tax ramifications associated with the loss of the ability to obtain a step-up to the fair market value (FMV) of the asset at the grantor’s death, many grantor trusts include a power of substitution so that a grantor might “swap” out low-basis assets for cash or higher-basis assets of equivalent value. The swap power is just one of a number of powers or transactions that might result in an irrevocable trust that holds completed gifts being taxable for income tax purposes to the grantor.

Revenue Ruling 2023-2

Rev. Rul. 2023-2 makes clear the IRS’ position in the debate regarding whether a grantor trust generally will be afforded a step-up in basis under Section 1014 when the property at issue isn’t includible in the grantor’s gross estate for federal estate tax purposes. (Rev Rul. 2023-2, at fn 4, clarifies that this ruling doesn’t alter the results of Rev. Rul. 84-139, with regard to property acquired from a nonresident noncitizen decedent that wasn’t included in the decedent’s gross estate, but was acquired by bequest, devise or inheritance or one of the other six types of property considered to be acquired from a decedent under provisions of Section 1014(b)).

In the facts outlined in the revenue ruling, the grantor established and funded an irrevocable trust. The transfers to the trust were a completed gift for gift tax purposes. The only rights retained by the grantor were those necessary to have the grantor treated as the owner of the trust for income tax purposes. The grantor didn’t retain any power over the trust that would result in inclusion of the trust’s assets in the grantor’s gross estate for federal estate tax purposes. By the time the grantor died, the FMV of the assets of the trust had appreciated, the liabilities of the trust didn’t exceed asset basis and there were no outstanding notes between the grantor and the trust.

The revenue ruling addressed the seven types of property considered to qualify for a basis adjustment at a decedent’s death under Section 1014 and held that property is generally only considered to “have been acquired from a decedent to the extent such property is includible in the decedent’s gross estate if the decedent died after December 31, 1953.”

Under the facts presented, the property wasn’t a bequest, devise or inheritance from the decedent within the ordinary meaning of those terms and didn’t fall within one of the six other types of property listed in Section 1014(b) that qualified for basis adjustment at a decedent’s death.

Debate Settled

With the issuance of Rev. Rul. 2023-2, the IRS has clearly delineated its position and settled the debate. The basis of an asset in a grantor trust for income tax purposes, but which isn’t includible in the grantor’s gross estate for federal estate tax purposes, will remain the same as it was immediately before the grantor’s death because it doesn’t constitute a “gift, bequest or devise from a decedent.”

Sandra D. Glazier, Esq., is an equity shareholder at Lipson Neilson, P.C., in its Bloomfield Hills, Mich., office and is a member of Trusts and Estates’ Editorial Advisory Board Planning & Taxation Committee. 

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