New IRS Ruling Disrupts Step Up Cost Basis for Intentionally Defective Irrevocable Trusts

Jul 26

A common strategy among estate planning attorneys is to use intentionally defective grantor trusts to give their clients the best of both tax worlds - minimizing estate taxes for the client while maximizing income tax savings for their family.

However, in Rev. Rul. 2023-2, the IRS finally closed a major loophole that made this possible. The basic idea is that there is a disconnect in estate tax law and income tax law. By including a particular provision in an irrevocable grantor trust, it would allow the asset to not be includable in the grantor’s (the creator of the trusts) estate for estate tax purpose, but would still allow the asset to receive what is called a stepped up basis under income tax rules.

The benefit of this approach would be that the beneficiaries of the trust (after the grantor’s death) would have the cost basis of the property reset (or stepped up) to its fair market value as of the grantor’s date of death. This means that when the property is then sold, it would have little to no capital gains tax, which is generally worth hundreds of thousands of dollars in income tax savings for clients who bought real estate (or other investments) decades ago.

So, if you have a grantor retained annuity trust, life insurance trust, qualified personal residence trust, or other type of intentionally defective grantor trust and were relying on a stepped up basis for the underlying assets, then you should be aware that those assets will not receive a stepped-up basis upon your death.

Despite the change, some practitioners are happy with the revenue ruling because it provides clarity and also reinforces the benefit of a power of substitution clause in your irrevocable trust. This power allows you to shift a high basis asset into the trust in exchange for a low basis asset without creating a taxable event.

What does this mean for you?

If you have made a “completed” transfer for gift tax purposes to your trust, then do not expect a stepped up cost basis on your assets held in that trust upon your death. If you not made a completed transfer to your irrevocable trust (for example, if you retained a power of appointment over the property), then you will still receive a stepped up basis because such asset will still be includable in your estate for estate tax purposes anyway.