Earlier this year the IRS released Revenue Ruling 2023-2. That Ruling examined a common situation in advanced estate planning. The grantor had set up an irrevocable trust and had gifted assets to the trust in what was a completed gift for gift tax purposes. The taxpayer retained powers which caused the trust to be taxed to the grantor for income tax purposes but did not cause inclusion for estate tax purposes. There are several such powers, such as the power to substitute assets under Code Section 675(4). The Ruling did not specify exactly which power had been retained to trigger grantor trust status.
A trust that is taxed to the grantor for income tax purposes (under the provisions of Code Sections 671 and following) is often called a “grantor trust.” A grantor trust which is not included in the taxable estate of the grantor is often called “intentionally defective.”
The Ruling looked carefully at Code Section 1014, which provides for a “step-up” in income tax basis when property is included in the estate of a decedent. The Ruling looked at the clear language of the Code and determined that it did not apply to property that was merely income taxable to the decedent since such property wasn’t acquired or passed from the decedent by bequest, devise, inheritance, or otherwise, as required by the Code section. (Sometimes, even property included in the taxable estate will not qualify for the step-up in basis, such as “Income in Respect of a Decedent,” e.g., an IRA.)
This Ruling did not break new ground. It merely confirmed what I already knew. Under Section 1014, a “step-up” in basis is only available when the assets are included in the taxable estate of the decedent.
The step-up in basis under Section 1014 may be one of the biggest tax loopholes. It allows the gain to escape income taxation entirely. For example, let’s say a taxpayer owns an asset, “Blackacre,” which they purchased for $50,000. Years later, moments before the taxpayer’s death, Blackacre is worth $500,000. If the taxpayer sold Blackacre before their death, they would owe tax on the appreciation of the asset. ($500,000 less their “basis” of $50,000, for a gain of $450,000.) Let’s say the tax rate on their gain was 20%, then they would have owed $90,000 in tax. However, if the taxpayer died before selling Blackacre, Blackacre would have received a new “basis” of the property’s market value as of the date of the taxpayer’s death, or $500,000. (While this is commonly known as the “step-up” in basis, if the value decreased, there may be a “step-down” in basis.) Thus, in this case the taxpayer’s estate or beneficiaries would owe no income tax when they sold the property after the taxpayer’s death for the stepped-up value.
However, to qualify for this loophole, the assets must be included in the decedent’s taxable estate. As the Ruling demonstrates, the fact the assets are in a trust which is income taxable to the taxpayer isn’t sufficient to qualify for this loophole, unless the assets are also included in the decedent’s taxable estate.