Introduction
With the new IRS Revenue Ruling (“Rev. Rul.”) 2023-2[1] passed in March, now may be a good time to revisit your irrevocable trust and estate plans.
The takeaway of Rev. Rul. 2023-2 is that the estate planner must choose between including their irrevocable trust as part of their estate at death for tax purposes or leaving their irrevocable trust out of their estate but at the expense of being subject to more capital gains taxes (losing the step-up in basis)[2].
The estate planner should strategize whether it is better for them to be paying federal estate taxes or capital gains taxes. For federal estate taxes, the decision is obvious for people with estates under $12.92 million (per person – 2023 number), because they are exempt from federal estate taxes. Those riding the margin or subject to federal estate taxes will want to take a closer look at their estate. Also, in 2026, the federal estate taxes’ threshold is set to cut in half so now is a great time for people to revisit their estate plans.
Explanation
- Irrevocable Trusts.
An irrevocable trust is a trust that you (the “grantor”) can create and put assets into, but you give up control of such assets.[3] The assets in the trust are not currently held by you, the grantor, nor have they passed to the beneficiaries. In doing this, you effectively reduce the size of your estate by the value of the assets you put into your irrevocable trust, which can effectively reduce estate taxes you will have to pay.
Here is an example using federal estate tax numbers. Your estate is $15 million. To avoid paying federal estate taxes, you put $5 million into an irrevocable trust that you will pass on to your children. This $5 million in the irrevocable trust is no longer considered part of your estate, which makes your estate worth $10 million. This is under the $12.92 million federal estate tax threshold, so you avoid paying “federal” estate taxes, and pass on the $5 million to your beneficiaries (here children) through the irrevocable trust.
- Revenue Ruling 2023-2.
Here is how the Rev. Rul. 2023-2 “tweaked” things. Now, if you exclude the $5 million in your irrevocable trust from your estate of $10 million, the assets in your trust may be subject to more capital gains taxes. Alternatively, you could consider the irrevocable trust as part of your estate (so $15 million again) and pay federal estate taxes.
Here, you will want to analyze whether you will save more money by paying less in estate taxes or paying less in capital gains taxes.
To clarify, let’s say you bought stock for $50,000 and you put it in an irrevocable trust. Over time the stock appreciates to $200,000. Before Rev. Rul. 2023-2, when you (the grantor) died, the irrevocable trust when passed on to your beneficiaries would “step-up in basis” meaning the stock would be considered $200,000 in basis when passed on to your beneficiaries.[4] The benefit of this is that essentially no capital gains taxes would be recognized for income tax purposes. Remember too that this irrevocable trust would not be considered part of your estate either for calculating estate taxes – or at least you can choose for it not to be.
Now, with Rev. Rul. 2023-2, the IRS says that if your irrevocable trust is not included with your estate, then there will not be a step-up in basis – meaning your stock basis will be $50,000 instead of $200,000 when passed on to your beneficiaries.[5] This means your beneficiaries will have to pay $150,000 in capital gains taxes on the stock that appreciated, if, the stock is not included in the grantor’s estate. Including it in the estate though, can subject the grantor to more estate taxes, but the basis for the stock will be $200,000 instead of $50,000 effectively dodging capital gains taxes.
Therefore, the question that remains is do you save more money by considering your trusts as part of your estate, or not? It will depend on your individual circumstance.
[1]https://www.irs.gov/pub/irs-drop/rr-23-02.pdf.
[2]https://kpmg.com/us/en/home/insights/2023/03/tnf-rev-rul-2023-2-no-basis-step-up-for-assets-of-irrevocable-grantor-trust-not-included-in-grantors-estate.html.
[3]https://www.law.cornell.edu/wex/irrevocable_trust#:~:text=Irrevocable%20trust%20refers%20to%20any,the%20trust%20after%20its%20creation.
[4]https://www.reuters.com/legal/transactional/irs-confirms-that-completed-gifts-grantor-trusts-are-not-eligible-section-1014-2023-06-21/.
[5]https://www.ghjadvisors.com/publications/tax-alerts/revenue-ruling-2023-2-addresses-basis-step-up-for-assets-owned-by-certain-trusts.