The IRS has ruled that for federal estate tax purposes a long-used basis adjustment under Sec. 1014 generally doesn’t apply to the assets of an irrevocable grantor trust that aren’t included in the deceased grantor’s gross estate.

“Over the years, more aggressive tax practitioners have sought to exclude trust assets from their client’s estate while simultaneously adjusting them for basis step-up at death,” said Liting Chuang, director of tax planning and associate wealth advisor at Bordeaux Wealth Advisors in Menlo Park, Calif.

After years of pressure from Congress to close the perceived basis adjustment loophole, Chuang said, Revenue Ruling 2023-2 is the first effort by the IRS to formally clarify basis adjustment for intentionally defective irrevocable trusts under IRC Sec. 1014.

“Irrevocable grantor trusts have a dual, and somewhat conflicting, nature: The income earned by the trust is included in the grantor’s taxable income, but the assets within the trust are excluded from the grantor’s estate for federal estate tax purposes,” said Sophia Duffy, a CPA and associate professor of business planning at The American College of Financial Services in King of Prussia, Pa. “The question is whether the assets in the trust receive a basis adjustment to fair market value at the decedent’s death, commonly referred to as step-up basis.”

“There was debate on this potential basis adjustment leading up to Revenue Ruling 2023-02, but I believe that many practitioners were already taking positions consistent with the holding,” added Azriel J. Baer, partner in the trust and estates group at the law firm Farrell Fritz in Uniondale, N.Y.

“Assume a client gifted property with an income tax basis of $1 million to a trust in year one and died in year 10 when the property had a fair market value of $10 million,” Baer said. “If the trustees then sell the appreciated property for $10 million, the trust would need to pay capital gains tax on $9 million. This capital gains tax could distort the overall estate plan if the grantor had completed the rest of his planning assuming this trust would receive a basis adjustment at death.”

“Ruling 2023-02 confirmed what many practitioners already believed – or at least tell their clients,” said Thomas Pontius, financial planner at Kayne Anderson Rudnick in Los Angeles. The argument hangs around the language in Sec. 1014 that says what types of assets qualify for the step-up, he said: “‘Acquired by bequest, devise, or inheritance otherwise within the meaning of §1014(b)…’ This revenue ruling looks to clarify that gifted assets to an irrevocable grantor trust do not apply to this.”

The main planning benefit of the irrevocable grantor trust is that a gift to the trust is treated as a complete gift for gift tax purposes, which removes future appreciation of the asset from the taxable estate of the grantor while permitting the grantor to continue to pay income taxes on the trust,” said Jennifer Junker, chief fiduciary officer at Arden Trust Company in Atlanta. “Payment of income taxes is not treated as a gift.”

“Revenue Rulings are not binding on any federal court, including the Tax Court, as they represent arguments of one party,” said Frank Corrado, managing director, principal at Robertson Stephens Wealth Management in Holmdel, N.J.

Nevertheless, tax-sensitive clients might explore philanthropic strategies to minimize estate and income taxes. Clients can also consider paying the capital gains tax on the tax return as if the assets did not receive an adjustment in basis. “They then file an amended tax return requesting a refund based on the assets receiving a step-up basis and providing full disclosure that this position was taken,” Corrado said. “If the step-up is denied, the taxpayer would not have made a substantial underpayment on the original return.” 

How serious is this ruling? “It’s likely that taxpayers might litigate this issue in the future, so the matter may not be fully settled. In the interim, following the IRS ruling is likely the safest course of action,” Duffy said.

“If a client’s attorney or CPA preparing the tax returns wants to take and defend the position that these assets should receive the step-up,” Pontius said, “make sure the client is aware of the risks and costs.”