Editor’s note: This is part 11 of an ongoing series about using trusts and LLCs in estate planning, asset protection and tax planning. The effectiveness of these powerful tools — especially for asset protection and tax planning — depends very much on how they are configured to work together and whether certain types of control over assets and property are surrendered by the property owner. See below for links to the other articles in the series.
Some trust makers and taxpayers have been confused about, or perhaps in denial of, the tradeoffs between control over assets and the capital gains tax planning potential of irrevocable trusts.
They had been hoping that by paying income taxes on the income of a completed-gift trust under the grantor trust powers, the trust would be eligible for both a step-up in basis and for estate tax exclusion. This double-dip benefit was simply too good to be true.
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An irrevocable trust can be treated as a grantor trust, which means that an individual (typically the trust maker) will be treated as the owner of the trust income or principal, and the individual will include all items of trust income, deductions and credits on their personal taxes, as though the individual had received them personally — even if the trust didn’t distribute the income to them personally and the income stays in trust.
Most people will save on the total taxes due on trust taxable income by paying the taxes themselves at their individual tax rates, which are usually lower than the trust tax rates, making the use of grantor trusts an attractive tax savings strategy.
An IRS clarification
In early 2023, the IRS issued Revenue Ruling 2023-02, under which the IRS clarified that if the assets in an irrevocable trust are excluded from the trust maker’s gross estate, then the estate-excluded assets will not get a step-up in basis for capital gains tax under Internal Revenue Code Section 1014, even if the irrevocable trust maker continued to pay income taxes on the trust income under the grantor trust income tax rules. In other words, Revenue Ruling 2023-02 was dispelling confusion and conflation of very different sets of trust tax rules: the income tax rules, the capital gains tax rules and the gift and estate tax rules.
While the impact of Revenue Ruling 2023-02 was exaggerated by some, it was really just a clarification of existing laws, rather than a dramatic change. The reality is that Revenue Ruling 2023-02 reiterated what many tax-savvy estate planning attorneys already knew to be clear: Property which is transferred to an irrevocable trust under a completed gift does not qualify for a step-up in basis for capital gains tax savings, even if the trust maker continues to pay the income taxes on the trust.
However, Revenue Ruling 2023-02 came as a shock to some attorneys and trust makers who had hoped to have their cake and eat it, too, by both paying trust income taxes under the lower individual tax rates, excluding property from the gross estate and getting a step-up in basis to save on capital gains taxes.
The step-up-in-basis technique
Keeping a trust as grantor status so that the trust maker personally pays the trust taxes at lower rates has never been a valid technique to step up the basis in completed-gift trust assets that are outside of the trust maker’s gross estate. Grantor trust income rules treat an individual taxpayer as the owner of trust income or principal so that the person pays income taxes on the trust income (usually at lower individual tax rates), instead of the trust paying taxes on trust income (usually at higher trust tax rates).
On the other hand, a completed gift of property out of the trust maker’s gross estate has always resulted in denial of the step-up in capital gains tax basis at the time of death.
To restate the key issue, it is essential for a trust maker to realize that they cannot both make a completed gift out of their taxable estate and qualify for a step-up to the basis in trust assets simply by making the trust assets grantor status.
Other Articles in This Series
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
