Tax Impact of Revenue Ruling 2023-2

How Revenue Ruling 2023-2 Affects Defective Grantor Trusts and Basis Step-Up

Revenue Ruling 2023-2 has recently generated significant interest among taxpayers and their advisors in estate planning and tax law. This ruling provides crucial guidance on treating intentionally defective grantor trusts (IDGTs) for income and estate tax purposes, particularly regarding a step-up in basis. Understanding the implications of this ruling is essential for effective estate planning strategies.

First, let’s briefly review the concept of IDGTs. An IDGT is a valuable estate planning tool that allows a grantor to transfer assets into a trust while retaining certain powers or interests that render the trust “defective” for income tax purposes but not for estate tax purposes. In simple terms, the assets transferred to the IDGT are removed from the taxpayer’s estate for federal gift and estate tax purposes while still being taxable to the grantor for income tax purposes. This defectiveness allows the grantor to personally report and pay the trust’s income taxes, reducing their taxable estate. Additionally, an IDGT facilitates the transfer of appreciating assets, effectively removing future appreciation from the grantor’s taxable estate.

Revenue Ruling 2023-2 addresses a scenario where a grantor makes a lifetime gift of certain assets to an IDGT established to benefit 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. This means that these assets, as owned by and received through an irrevocable trust, are not considered received by bequest, devise, or inheritance and are thus not eligible for a step-up in basis under IRC § 1014(b). A step-up in basis allows a taxpayer to sell inherited assets without paying any capital gains taxes accrued during the decedent’s lifetime.

Previously, there was some contention among practitioners regarding whether assets gifted to an IDGT would be eligible for a step-up in basis due to their taxable status to the grantor. However, Revenue Ruling 2023-2 definitively clarifies that these assets are not received through bequest, devise, or inheritance and are therefore ineligible for a step-up in basis. Importantly, although these assets do not receive a step-up in basis for income tax purposes, they remain a completed gift and are removed from the grantor’s taxable estate for gift and estate tax purposes.

This ruling clarifies the income tax treatment of gifts made to IDGTs. While it confirms that these assets are not eligible for a step-up in basis, it also reaffirms the effectiveness of IDGTs as powerful vehicles for wealth transfer, particularly for gift and estate tax purposes.

Revenue Ruling 2023-2 also emphasizes the importance of careful planning and strategy when using IDGTs. A power that renders 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. Using this power, the grantor can effectively substitute a promissory note for low-basis assets, making them eligible for a step-up in basis when owned by the grantor instead of the IDGT. This strategy is particularly advantageous for grantors who are elderly or facing terminal health issues.

In conclusion, Revenue Ruling 2023-2 clarifies the treatment of IDGTs on a step-up in basis. This ruling confirms the ongoing effectiveness of these estate planning strategies, enabling grantors to retain a level of control over trust assets while reducing their taxable estate. However, it highlights the importance of proactive planning to ensure compliance and optimize estate planning strategies. Your Considerate Capital advisor working with a qualified attorney can review existing IDGTs to ensure compliance and maximize the benefits of these strategies, following the guidelines outlined in Revenue Ruling 2023-2. With careful planning and adherence to the ruling, individuals can effectively utilize IDGTs as powerful tools for wealth transfer and tax optimization.