Episode 231 – The IRS released Revenue Ruling 2023-2 stating that assets held in a grantor trust do not receive a step-up in basis upon the grantor’s death. What does that mean?

Hello this is Bill Rainaldi, with another edition of Security Mutual’s SML Planning Minute. In today’s episode, No Step-Up in Basis for Assets in a Grantor Trust.

On March 29, 2023, the IRS issued Revenue Ruling 2023-2 to settle a tax question that some estate planning attorneys and tax commentators believed to be in question. Let’s briefly discuss the issue that you and your legal and tax advisors may need to decide if it applies to you.

Grantor trusts (a/k/a “intentionally defective grantor trusts” or “defective trusts”) are very common estate planning tools used by high net-worth individuals, who may have an estate tax exposure upon death. Generally, the person making the gift, referred to as the grantor, transfers assets through gifts into an irrevocable trust designed to be a grantor trust. Retention of certain powers by the grantor that satisfy Internal Revenue Code Sections 671, et seq., would allow an irrevocable trust to be considered a grantor trust.

Grantor trust status generally means that the assets transferred are no longer considered owned by the grantor for gift and estate tax purposes. For income tax purposes, however, the grantor is still considered the owner and is subject to the income tax consequences resulting from those assets, such as the payment of income tax on taxable income generated by those assets. From an estate planning perspective, the gifting of assets into an irrevocable trust removes the value of the asset, and its potential future growth, from the value of the taxable estate at death. Payment of income taxes on income generated by the trust asset further depletes the taxable estate.

One of the basic axioms of estate planning is that assets acquired or passed from a decedent, as defined in Internal Revenue Code Section 1014, receives a basis adjustment to the fair market value as of the date of death (i.e., “step-up in basis”). What does that mean? Let’s review a simple example. A parent purchased an asset years ago for $10. That is the parent’s basis. It is now worth $100, and the asset is gifted to a child. The child’s basis remains at $10. That’s known as “carryover” basis. The child turns around and sells the asset for $100. The child is now subject to $90 of capital gains. Contrast that to the situation where the asset is passed to the child through a bequest, because of the parent’s death. The child’s basis in that asset has been “stepped up” to its fair market value on the date of death, which is $100. If the child immediately sells the asset for $100, there would be no capital gains.

Some prominent estate planning attorneys and tax advisors have argued for years that assets placed into a grantor trust should still receive a basis step-up upon the death of the grantor. They reason that nothing in Internal Revenue Code Section 1014, the applicable regulations, or legislative history, expressly precludes transfers made under a lifetime trust from qualifying as a bequest or devise at death. Since the assets in a grantor trust are still deemed owned by the grantor during the grantor’s lifetime, for income tax purposes, an argument can be made that the assets passed as a result of the death of the grantor, since the trust no longer qualifies as a grantor trust at the moment of death. Therefore, the assets in the trust should receive a “step-up” in basis upon the death of the grantor.

Revenue Ruling 2023-2 declared the IRS’s official position that assets held in a grantor trust do NOT receive a basis “step-up” upon the death of the grantor. Since that Revenue Ruling was issued, commentators have continued the debate, noting that a Revenue Ruling while an official interpretation by the IRS on how the law is applied to a specific set of facts, a Revenue Ruling does not have the same force and effect as a statute, regulation, or court case. But it must be pointed out that if a taxpayer continues to argue the counterpoint, the IRS may also seek to apply penalties and interest.

So, while the IRS has issued a Revenue Ruling, the debate is far from over. Aggressive taxpayers may decide to challenge the IRS’s position.

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