IRS says “Wait a Minute” on Stepping-up Basis for Assets in Irrevocable Trust

Until recently, the IRS has said little (if anything) regarding whether assets the beneficiary of an irrevocable trust receives get a step up in basis following the Grantor’s death. With issuance of Revenue Ruling 2023-2, that has changed. The IRS has spoken. In RR 2023-2, the IRS posed the following hypothetical which I’ve edited slightly:

John established an irrevocable trust and funded the trust by conveying Blackacre. The transfer was a completed gift for tax purposes. John retained power over the trust causing it to be owner of the trust for income tax purposes. John did not hold a power over the trust that caused the trust to be included in his estate for estate tax purposes. Seven years after the trust was established, Blackacre’s value had appreciated. At the time of John’s death, the trust’s liabilities did not exceed Blackacre’s basis and neither John nor the trust held a note on which the other was the obligor. Under these facts, do the remainder beneficiaries of John’s trust get a step-up in basis (also called a basis adjustment)?

What is “basis” for tax purposes?

While certain facts may alter this generalization, under Section 1012(a), “basis” is essentially what property cost at the time of purchase. So under this hypothetical, John’s basis is what he paid for the property. If John’s beneficiary takes John’s basis (usually called a carry over basis), then the beneficiary is deemed to have paid the same price John paid. Therefore, subject to nifty tax planning (deductions, recapture rules and other bizarre provisions of the tax code), capital gains taxes are generally assessed on the profit. Profit is the difference after subtracting basis from the sales price. See What is Capital Gains Tax?

In general terms, Section 1014(a) provides that when property is acquired from a decedent, basis is the fair market value at the date of the decedent’s death (or the alternate date – Section 2032). Basis adjustment is substitution of the FMV as of the decedent’s daet of death for the original purchase price. When basis adjustment is allowed, the capital gains tax may be significantly reduced or eliminated altogether.

What changed with Rev. Rul. 2023-2?

Prior to RR 2023-2, some planners thought assets in an intentionally defective grantor trust (IDGT) were eligible for basis adjustment. The IRS says otherwise. It used Black’s Law Dictionary, a  1923 Supreme Court case and a 1961 Sixth Circuit case to narrowly define the terms “bequeathed,” “devised,” and “inherited.” RR 2023-2 finds that a “bequest” is the act of giving property, usually personal property, by Will. A “devise” is the act of giving property, usually real property, by Will. An “inheritance” is property received from an ancestor under intestacy laws or that a person received as a bequest or devise. Using these definitions, the IRS concluded that Blackacre was not ”bequeathed,” “devised,” or “inherited” within the meaning of § 1014(b)(1) and did not fall within any of the remaining types of property listed in Section 1014(b). As a result, the beneficiaries do not get a basis adjustment, “because Asset was not acquired or passed from a decedent as defined in § 1014(b).”

The articles reviewing RR 2023-2 note that a traditional IDGT is used to freeze asset values for estate tax purposes. These IDGTs are drafted to cause inclusion of the asset for income tax purposes, but exclusion for estate tax purposes. If John’s trust had been drafted so Blackacre was included his in estate for purposes of calculating potential estate tax, then it should receive a basis adjustment pursuant to Section 1014(b)(9) and (b)(10). Although inclusion might not achieve the goals of wealthy taxpayers since it does not freeze asset values, it means most middle class taxpayers can use irrevocable income-only trusts for Medicaid planning and still get the desired stepped-up basis. See 26 CFR § 1.1014-1(a)