In March of this year, the IRS issued Revenue Ruling 2023-2. This ruling provides clarity on how assets are treated when you transfer them into an irrevocable trust. The ruling basically says that when an asset is transferred into an irrevocable trust during the owners lifetime (and removed from the owner’s estate), that asset will not qualify for a step-up in basis on the original owner’s later death. But, what does all of that mean? Let’s break it down.
An irrevocable trust is an estate planning tool used by attorneys for a variety of purposes. Moving assets into an irrevocable trust can help you avoid probate, protect assets from creditors, minimize income taxes, and avoid federal estate taxes. Irrevocable trusts can also be a helpful tool when trying to financially qualify for government benefits.
The key feature of an irrevocable trust is that it’s irrevocable. This means that the grantor (the person putting assets into the trust) can’t make changes to the trust. This can be stifling, but for some, it is the most appropriate estate planning tool.
Sometimes, but not always, an irrevocable trust leaves the original owner with little or no control over the trust’s contents. That might support an important planning goal, like getting the trust assets out of the owner’s estate to help reduce estate taxes. One popular variant: a “defective” grantor trust might get the asset out of the grantor’s estate, while maintaining the income tax liability on the grantor’s income tax return.
According to the IRS, the basis of an asset is “generally the amount of your capital investment in property for tax purposes.” Usually, the basis is how much you paid for the asset, plus costs you’ve invested in the asset since purchase (like remodeling costs, or additional purchases). It is important to know what the basis of an asset is important to calculate your capital gains and losses. When you sell an asset for more than what it initially cost, you have a capital gain and you could be taxed on it.
A step-up in basis considers the fair market value of an asset when it was inherited rather than when it was acquired. The step-up in basis is the fair market value of the property when it was inherited rather than the cost of the asset when it was originally purchased. This is usually the value of the asset on the date of the grantor’s death.
A step-up in basis can be a huge benefit when legacy planning. Let’s say for example that your parents bought a house for $100,000 decades ago. As the market goes up, so does the value of that house. Let’s say today, the house has a fair market value $500,000. If your parents sell it, they would be subject to capital gains taxes on the $400,000 gain on the house. Instead, if you inherit the house, you inherit the house with a step-up in basis. Assuming the house was worth $500,000 when your parents died, the stepped-up basis of the house would be $500,000. You would also use $500,000 as the basis to calculate capital gains if you sold the house in the future.
Using a stepped-up basis, you can minimize your capital gain taxes on assets passed down from generation to generation. And wouldn’t it be great if you could get the asset out of your taxable estate while still getting the step-up in basis for your heirs?
One technique some have used for that purpose is a special type of irrevocable trust. Because the original owner (the “grantor”) keeps some control over trust assets, it remains a “grantor trust.” That means the grantor pays the income tax on trust earnings — which can mean that the real value of any gift is increased by the taxes paid. It also means that tax rates are kept lower than they would be if the trust paid its own income taxes.
So the goal has been to make the gift complete, but to keep the “grantor trust” status. That makes it look like the trust is defective. But it’s actually, as they say, a feature rather than a bug. So trusts like that acquired a catchy name: the “intentionally defective grantor trust,” or IDGT. Even the acronym seems catchy!
One reason IDGTs are popular: the disconnect between federal income tax and federal estate tax rules. So an IDGT can keep the income tax liability on the donor’s tax return, while removing the asset from the estate tax return. But could you argue that an IDGT’s assets should get a step-up in basis on the donor’s death?
The Internal Revenue Service released its Revenue Ruling 2023-2 in March of this year. It clarifies that a transfer into an irrevocable trust can take the trust assets out of the grantor’s estate for all purposes. If the asset is no longer part of the grantor’s taxable estate, it will not qualify for a step-up in basis. This means the assets in your irrevocable trust keep the same basis as they are transferred to the next generation — or maybe to multiple generations.
Let’s return to our previous example. Let’s say your parents put the house they bought for $100,000 into an irrevocable trust with you as the beneficiary. The new ruling says that the asset does not get a stepped-up basis. So, when your parents die and the trust is administered the basis of the house remains $100,000, regardless of what the value of the house is at the time of their death. This means that if you sell the house, you will have to calculate your capital gains using the $100,000 basis. This can be a major drawback to moving assets into an irrevocable trust depending on your goals.
There are other ways to avoid or minimize income taxes, depending on the particular circumstances. If, for instance, your parents live in the home described in our example, they might not have to pay any income taxes on its sale during their lives. That’s because they might qualify for a special income tax deduction for homeowners.
Tax rules exempt up to $500,000 in capital gains on sale of a residence from taxation. So if your parents sell the $500,000 home (with a $100,000 basis) while they’re both still alive, they probably won’t pay any income tax on the sale. That exemption applies if they lived in the home for at least two of the five years before sale.
But if they die still owning the home, their estates don’t qualify for that special treatment. Then their heirs (you) would hope to get the step-up in basis from inclusion in their taxable estate(s).
Is an IDGT right for you? It might be — particularly if you have a very large estate and you worry about ultimate estate tax liability.
We’ve used a home as our example because it’s easy to understand. But most IDGTs don’t hold a piece of real estate, and especially not the donor’s residence. There are actually other sophisticated estate planning techniques to look into for even very valuable residences.
More commonly, IDGTs hold a portion of the donor’s business. They are often part of the transition planning for a businessperson looking to transfer the family business to the next generation. But with Revenue Ruling 2023-2, the IRS has clarified that one of the commonly-sought techniques for tax minimization just might not work. Even so, the value of the planning might make an irrevocable trust a useful idea.
