Revenue Ruling 2023-2 Denies Step-Up in Basis for Trusts

The Internal Revenue Service (IRS) issues official interpretations of tax law called Revenue Rulings, which are binding on the agency and provide guidance for all taxpayers. A directive, Revenue Ruling 2023-2, has drawn attention from estate planners because it clarifies the tax rules for assets held in certain trusts after the creator’s death.

The Taxpayer Situation Addressed

Revenue Ruling 2023-2 examines a specific estate planning scenario involving an irrevocable trust. In the situation, an individual, referred to as the grantor, creates and transfers assets into a trust. A key feature is that this trust is irrevocable, meaning the grantor cannot unilaterally amend or terminate it. This action removes the assets from the grantor’s personal ownership and, consequently, from their future taxable estate.

The trust in question is also structured as a “grantor trust” for federal income tax purposes. This is achieved by the grantor retaining certain powers over the trust, such as the power to swap trust assets with other assets of equal value. This structure means that although the assets are legally owned by the trust, all income generated by it is reported on the grantor’s personal income tax return, and the grantor is responsible for paying any resulting tax.

The central issue arises from the nature of the powers the grantor retained. While these powers were sufficient to trigger grantor trust status for income tax, they were intentionally designed not to be strong enough to cause the trust’s assets to be included in the grantor’s gross estate for federal estate tax purposes upon their death. This is a common strategy used to reduce a taxable estate while the grantor continues to pay the income tax on trust assets, which further benefits the trust beneficiaries.

The ruling considers what happens after the grantor passes away. At the time of death, the assets remain within the irrevocable trust, which continues to operate for its named beneficiaries. The question for the IRS was how the tax basis of these assets should be determined, given that they were part of a grantor trust but were not part of the decedent’s gross estate.

The IRS Conclusion on Basis Adjustment

The conclusion delivered by the IRS in Revenue Ruling 2023-2 was direct. The agency determined that the assets held within the irrevocable grantor trust do not receive an adjustment, commonly known as a “step-up,” in their cost basis to the fair market value at the date of the grantor’s death.

This means the basis of the assets for tax purposes remains unchanged by the grantor’s death. The trust and its beneficiaries will use a “carryover basis” for the assets. This carryover basis is the same as the grantor’s original basis, which is the price the grantor initially paid for the assets, plus any adjustments for improvements or depreciation.

Instead of the basis resetting to the higher market value at death, it stays at the original, often much lower, cost. This ensures that the built-in appreciation of the assets remains subject to potential taxation upon a future sale.

IRS Rationale for the Decision

The IRS based its conclusion on a strict interpretation of Section 1014 of the Internal Revenue Code. This section governs the rules for determining the basis of property acquired from a decedent. It states that for property to receive a basis adjustment to its fair market value at death, it must be “acquired or passed from a decedent.” The code provides a list of seven types of property transfers that meet this requirement.

The IRS analysis detailed that the assets held in the irrevocable trust did not fit into any of the qualifying categories. The property was not transferred through a bequest, a devise, or by inheritance under state intestacy laws. The transfer to the trust was a completed gift made during the grantor’s lifetime, not a transfer that occurred as a result of their death.

A basis step-up is tied to property that is included in a decedent’s gross estate for federal estate tax purposes. In the scenario addressed, the grantor’s retained powers were intentionally limited to avoid this outcome. Because the trust assets were not part of the decedent’s gross estate, they did not meet the criteria for property passing from a decedent that would trigger a basis adjustment. The IRS concluded that the lifetime gift to the trust severed the connection needed for the assets to be considered acquired from the decedent at death.

Tax Consequences for Trust Beneficiaries

The denial of a basis step-up has significant financial consequences for the beneficiaries of these trusts. With a carryover basis, the potential for a large capital gains tax liability is preserved. When the trust or a beneficiary eventually sells an appreciated asset, the taxable gain is calculated as the difference between the sale price and the grantor’s original low basis.

To illustrate, assume a grantor purchased stock for $100,000 and transferred it to an irrevocable grantor trust. At the time of the grantor’s death, the stock’s fair market value had appreciated to $500,000. If the trust later sells the stock for $550,000, the taxable capital gain is calculated from the original basis. The gain would be $450,000 ($550,000 sale price minus the $100,000 carryover basis).

This outcome contrasts with what would have occurred if a basis step-up had been permitted. In that scenario, the basis would have been adjusted to the $500,000 fair market value at the grantor’s death. A subsequent sale for $550,000 would have resulted in a taxable capital gain of only $50,000. The ruling confirms that the $400,000 of appreciation during the grantor’s life remains subject to capital gains tax.