IRS Revenue Ruling May Result In More Capital Gain Taxes For Beneficiaries Of Certain Irrevocable Trusts

IRS Revenue Ruling May Result In More Capital Gain Taxes For Beneficiaries Of Certain Irrevocable Trusts

Earlier this year, the IRS made a revenue ruling whereby assets transferred into an irrevocable trust without certain elements of retained control by the grantor (the one who established the trust) would fail to be entitled to a “step-up” in basis.  If an individual has highly appreciated assets (i.e., stocks, real estate, etc.) and retains elements of control until such person dies, there would be a recalculation of the basis to the value as of the date of death and capital gains taxes would only be on appreciation after the date of death.  However, if an individual (donor) merely gifts an appreciated asset to a donee, the donee would take the basis of the donor.  The donee would then be responsible for capital gains taxes on the sale of the asset based on the amount of appreciation.

So, for example, if the donor purchased Google stock at $50,000 and then gave the stock during life to his or her child and the child subsequently sold the stock for $250,000, then the child (donee) would have to pay capital gains tax on the $200,000 appreciation.  However, if the individual kept the stock until death or if the individual transferred the appreciated stock that was not sold prior to death to either a revocable trust or certain irrevocable trusts where elements of control were retained by the grantor, it would be included in the grantor’s estate since it was an incomplete gift.  As a result, there would be a step-up in basis and there would not be capital gains tax on the $200,000 appreciation.

Control is usually a key issue in determining who is responsible for various taxes (i.e., income taxes, estate taxes, capital gains taxes, etc.).  Estate planning attorneys often determine the goal of the client as to who should pay the various types of taxes in planning.

The type of trust that the Revenue Ruling addressed is an irrevocable trust whereby the grantor continued to be taxed on the income generated by the irrevocable trust, but the transfer was a completed gift for estate tax purposes.  Irrevocable trusts can be prepared in various ways.  Some irrevocable trusts retain no elements of control by the grantor.  As a result, the trust is taxed on the income generated by assets in the trust and there would be no adjustment in basis.  On the other hand, if the grantor retained various elements of control (using different sections in IRC) in the irrevocable trust so that the assets were not considered a complete gift and there was language whereby the grantor would also be taxed on the income (even if he or she didn’t receive the income), then the grantor could be taxed on both the income and there would be a step-up in basis so that the beneficiary would not have capital gains tax to the extent of the appreciation on asset if held until death.  This type of irrevocable trust (which we often use for estates with a value less than the estate tax limit of $12,920,000 to protect the asset from Medicaid spend down) was not a problem under the IRC revenue ruling since it would not be considered a completed gift as the grantor retained a power of appointment (the ability to change the beneficial interest).  So, if the grantor retains the power as to who is the beneficiary at death or how much the beneficiary would get at death, then transfers into the trust would be entitled to a step-up in basis at death.

However, if the grantor did not retain the power to appoint assets held in the trust, then the Revenue Ruling states step-up or adjustment in basis would fail to occur since it would lack being a completed gift and the beneficiary would get the basis of the donor/grantor.  The type of trust the IRS is attacking is often used in estate planning to transfer wealth to children or lower generations.  Often, the language in this type of irrevocable trust includes a power of substitution (grantor pays tax on the income, but the asset basis is carried over to the beneficiary).  So, even if a grantor thought they were going to get a step-up in basis prior to the Revenue Ruling and then was concerned about the Revenue Ruling (although a court such as a tax court could overturn the Revenue Ruling), the grantor could simply swap the appreciated asset (i.e., the Google stock) held in the trust with a non-appreciated asset such as cash or an asset with less appreciation.  Thus, if the grantor kept the stock until death, there would be a step-up in basis.  If the grantor did not have adequate cash, he or she could borrow money and then make a swap with the appreciated asset help in the trust with a promissory note.  Then, after the death of the grantor, the property with step-up is sold and is used to pay back the loan.  So, even though Revenue Ruling 2023-2 attacks this type of irrevocable trust (commonly known as an intentionally defective grantor trust), there are ways to plan so the step-up or adjustment in basis can be retained if desired.  Some wealthy taxpayers, in contrast, want to shift appreciation assets to not be part of his or her taxable estate.

Some estate planners disagree with the IRS Revenue Ruling that this type of trust should not get a step-up in basis since the grantor is still taxed on the income in the irrevocable trust.  Although some practitioners may want to see if this goes to court, those who want to reduce the risk of a fight with the IRS will simply follow the guidance by the Revenue Ruling and plan according to the goals of the client.

If interested in learning more about this article or other estate planning, Medicaid and public benefits planning, probate, etc., attend one of our free upcoming Estate Planning Essentials workshops by clicking here or calling 214-720-0102. We make it simple to attend and it is without obligation.

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