Analyzing Revenue Ruling 2023-2: Implications for Defective Grantor Trusts and Basis Step-Up

Revenue Ruling 2023-2, issued by the Internal Revenue Service (IRS), has recently garnered attention within the realm of estate planning and tax law. The ruling provides crucial guidance on the treatment of intentionally defective grantor trusts (IDGT) for income and estate tax purposes as it relates to a step-up in basis. Understanding the implications of this ruling is essential for both taxpayers and their advisors to navigate the complexities of estate planning strategies effectively.

Defective Grantor Trusts: A Brief Overview

Before delving into the specifics of Revenue Ruling 2023-2, let’s recap the concept of IDGTs. An IDGT is a powerful estate planning tool that allows the grantor to transfer assets into a trust while retaining certain powers or interests, which render the trust “defective” for income tax purposes but not for estate tax purposes. In other words, the assets transferred to the IDGT are removed from the taxpayer’s estate for federal gift and estate tax purposes, but not for income tax purposes. This defectiveness allows the grantor to personally report and pay the trust’s income taxes, further reducing the grantor’s taxable estate in the process. In addition, an IDGT serves as a vehicle to transfer appreciating assets, thereby removing all future appreciation from the date of the gift from the grantor’s taxable estate.

Revenue Ruling 2023-2: Key Highlights

Revenue Ruling 2023-2 addresses a scenario where a grantor makes a lifetime gift of certain assets to an IDGT established for the benefit of family members. In this ruling, the IRS confirms that the gifted assets, while taxable to the grantor for income tax purposes, are not eligible for a step-up in basis upon the grantor’s death. Specifically, IRC § 1014(b) allows a step-up in basis for assets which are received by a taxpayer by bequest, devise, or inheritance. This basis step-up essentially allows a taxpayer to sell inherited assets without payment of any capital gain taxes which accrued throughout the decedent’s lifetime.

Previously, some practitioners believed assets gifted to an IDGT may be eligible for this step-up in basis since the assets are still taxable to the grantor for income tax purposes. However, Rev. Rul. 2023-2 confirms that such assets are not received by bequest, devise, or inheritance since they are owned by and received through an irrevocable trust, and therefore not eligible for a step-up in basis. Importantly, while the gifted assets are not eligible for a step-up in basis for income tax purposes, they remain a completed gift, and removed from the grantor’s taxable estate, for gift and estate tax purposes.

Implications and Planning Strategies for Taxpayers and Advisors

Revenue Ruling 2023-2 provides welcomed clarity on the income tax treatment of gifts made to IDGTs. While this ruling definitively clarifies that assets gifted to an IDGT are not eligible for a step-up in basis, it does reinforce the continued viability of IDGTs as a powerful wealth transfer vehicle for gift and estate tax purposes.

Furthermore, the ruling highlights the importance of careful planning and strategy when utilizing IDGTs. One power that makes an IDGT “defective” for income tax purposes is a “power of substitution,” which allows the grantor to substitute assets of equal value to the IDGT in exchange for previously gifted assets. Often, this involves the substitution of a promissory note payable to the IDGT equal in value to the gifted assets that are pulled back out of the IDGT. Since the gifted assets are not eligible for a step-up in basis while owned by the IDGT, this power allows the grantor to substitute a promissory note for low-basis assets. In effect, this makes such low-basis assets again eligible for a step-up in basis since they are now owned by the taxpayer instead of the IDGT. This is an extremely powerful tax planning strategy for grantors who are elderly or otherwise suffering from terminal health issues.

Conclusion

Revenue Ruling 2023-2 provides clarity on the treatment of IDGTs as it relates to a step-up in basis. This ruling affirms the continued effectiveness of such estate planning strategies, allowing grantors to retain limited control over the trust assets while reducing their taxable estate. However, unless the grantor is proactive, this comes at the cost of not receiving a stepped-up basis in such assets upon the passing of the grantor.

In light of this ruling, Fraser Stryker attorneys are available to review existing IDGTs and consult with clients to ensure compliance and optimize their estate planning strategies. With careful planning and adherence to the guidelines set forth in Revenue Ruling 2023-2, individuals can utilize IDGTs as a powerful tool for wealth transfer and tax optimization.