The good news: Assets transferred to a revocable or “living” trust continue to receive the step-up.
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.
- 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.
- 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.
- 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.
Uses of an Irrevocable Trust. Irrevocable trusts offer two main benefits: (1) creditor protection during the grantor’s life; and (2) estate tax planning.
Creditor Protection. Assuming your irrevocable trust was drafted properly such that your transfers into it are considered completed gifts, then if you get sued, the assets in the trust will not be available to your judgment creditors.
Estate Tax Planning. Completed gifts into an irrevocable trust are no longer considered part of your estate, and, if utilized strategically, they allow you to stretch your lifetime gift allowance much farther than if your beneficiaries simply inherit from you directly.
American citizens who die in 2024 have $13.6 million of lifetime gift allowance to use, but unless Congress acts to extend that provision, the allowance will drop to approximately $6.2 million per individual starting January 1, 2026. If that happens, anyone who transferred more than $6.2 million into an irrevocable trust prior to 2026 will have locked in more exemption dollars than those who did not (and allowed them to expire.) Furthermore, gifts from an individual to an irrevocable trust can be leveraged through an LLC to take advantage of discounts for lack of control and marketability. Depending on the assets being gifted, that discount can be 25% to 50% of the asset’s fair market value. However, such discounts are off the table after the grantor passes away.
Revenue Ruling 2023-2 essentially closed a loophole that many estate planners have been using. Grantors can create an irrevocable trust and make completed gifts into it so that all of the benefits described above are realized, while also electing “grantor trust” status so that the grantor continues to pay all of the income tax on the assets within the trust. That increases the value of the gift, because trust principal and income do not have to be expended paying taxes, and it created an argument for a step-up in tax basis upon the death of the grantor.
With Revenue Ruling 2023-2, the IRS basically stated that the grantor has to choose now:
- If the grantor wants the step-up in basis, the asset has to be part of the grantor’s estate at death (and therefore subject to estate taxes).
- If instead the grantor wants the creditor protection, discounts for lack of control and marketability, and the option of locking in politically unstable exemption dollars, then the grantor loses the step-up in tax basis.
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.
