Rev. Rul. 2023-2 Denies Step-Up Basis for Grantor Trusts

The Internal Revenue Service (IRS) issued Revenue Ruling 2023-2, providing a definitive answer on a tax question involving assets held in specific types of trusts. This guidance clarifies that assets irrevocably gifted to a trust cannot benefit from a basis step-up upon the grantor’s death. The ruling resolves a long-standing ambiguity in estate planning and requires a reevaluation of many existing wealth transfer strategies.

Understanding Tax Basis Fundamentals

To appreciate the ruling’s impact, one must first understand tax basis. An asset’s tax basis is its original cost for tax purposes. When you sell an asset, the taxable gain is the difference between the sale price and your basis. For example, if you buy a stock for $100 and sell it for $150, your basis is $100, and you have a taxable capital gain of $50.

A concept in estate planning is the “step-up in basis,” governed by Internal Revenue Code (IRC) Section 1014. When an individual inherits an asset, the basis is adjusted to its fair market value at the time of the original owner’s death. If a person bought a home for $200,000 and it is worth $1,000,000 upon their death, the heir receives a new basis of $1,000,000, meaning the $800,000 of appreciation is not subject to capital gains tax.

Conversely, some asset transfers result in a “carryover basis,” which often occurs with lifetime gifts. When you receive a gift, you take on the original owner’s basis in the asset. If someone gifts you stock they purchased for $1,000 that is now worth $5,000, your basis is still $1,000. A sale at $5,000 would result in a taxable gain on the $4,000 of appreciation.

The Specific Trust Structure Addressed

The ruling focuses on the irrevocable grantor trust. An irrevocable trust is one where the terms cannot be modified or revoked by the person who created it, known as the grantor. Once assets are transferred into this trust, the grantor relinquishes ownership and control, and the assets are legally owned by the trust for its beneficiaries.

A unique feature of this trust is its “grantor” status for income tax purposes. Due to certain powers retained by the grantor under Internal Revenue Code sections 671-679, the grantor is treated as the owner of the trust’s assets for income tax reporting. This means all income and gains are reported on the grantor’s personal income tax return.

This structure creates a hybrid situation. For income tax purposes, the grantor is the owner. For estate tax purposes, the assets are generally excluded from the grantor’s gross estate because the transfer was a completed gift. This dual nature led to the question of whether the trust’s assets would qualify for the step-up in basis.

The IRS Conclusion in the Ruling

Revenue Ruling 2023-2 concludes that assets held in an irrevocable grantor trust do not receive a step-up in basis if those assets are not included in the grantor’s gross estate. The income tax status of the trust as a grantor trust is not sufficient to secure the basis adjustment at death.

The IRS’s rationale is rooted in the language of IRC Section 1014, which allows for a basis adjustment only for property “acquired or passed from a decedent.” When a grantor makes a completed gift to an irrevocable trust during their lifetime, the trust acquires the property at that moment. Upon the grantor’s death, the assets are already legally owned by the trust and do not pass from the decedent to the beneficiaries, failing to meet the statutory requirements for a basis step-up.

Tax Impact on Asset Beneficiaries

The practical consequence of this ruling is a potentially larger capital gains tax liability for beneficiaries. Without the step-up, the assets retain their original carryover basis. This means the beneficiary is responsible for the tax on all appreciation from the time the asset was first purchased by the grantor until it is sold.

Consider a numerical example. A grantor purchased stock for $200,000 and transferred it to an irrevocable grantor trust. At the time of the grantor’s death, the stock was worth $1 million. If the assets were to receive a stepped-up basis, the beneficiary’s basis would become $1 million, and a subsequent sale at that price would result in zero capital gain.

Under the guidance of Rev. Rul. 2023-2, the beneficiary receives the stock with the grantor’s original $200,000 basis. If the beneficiary sells the stock for its fair market value of $1 million, they will realize a capital gain of $800,000. Assuming a long-term capital gains tax rate of 20%, this would result in a federal tax liability of $160,000 that would have been avoided if the basis had been stepped up.