(June 21, 2023) - Eric N. Mann and Jacob H. Calvert of Neal Gerber Eisenberg discuss a Revenue Ruling that has confirmed the position of the Internal Revenue Service that completed gifts to grantor trusts are not eligible for a basis step-up under Section 1014 of the Internal Revenue Code upon the death of the grantor.

On March 30, 2023, the Internal Revenue Service issued Revenue Ruling 2023-2, which directly impacts a wide range of irrevocable trusts, including grantor retained annuity trusts, qualified personal residence trusts, insurance trusts and other intentionally defective "grantor trusts."

Revenue Ruling 2023-2 is brief. Per the Internal Revenue Service, completed gifts to an irrevocable grantor trust will not receive a basis step-up upon the death of the grantor. Mechanically, the Ruling concludes that this is the appropriate result because such property is not "acquired from a decedent" for purposes of Section 1014(a) of the Internal Revenue Code of 1986, as amended (the "Code") as described in Section 1014(b) of the Code.

Assets received from a decedent upon the death of the decedent are afforded a basis step-up under Code Section 1014. Typically, these are assets that are included in the taxable estate of a decedent for estate tax purposes. But prior to the Ruling, many practitioners wondered whether the assets of an irrevocable grantor trust would be eligible for the same benefit.

An irrevocable "grantor trust" is an anomaly under the Code. A "grantor trust" is not recognized as a separate taxpayer for income tax purposes during the lifetime of the creator (commonly referred to as the "grantor" or the "settlor"). All income earned during the grantor's lifetime is reported on the grantor's individual income tax returns. Yet, if the grantor trust is irrevocable, and if the transfers to the trust are deemed to be completed gifts, then upon the death of the grantor, the assets of the grantor trust are not included in the taxable estate of the grantor for estate tax purposes. So, a grantor trust is deemed to be owned by a grantor for income tax purposes, but not for estate tax purposes: thus, the uncertainty over the eligibility of the grantor trust assets for the Code Section 1014 basis step-up on the death of the grantor.

The uses of "intentionally defective" grantor trusts for estate planning purposes are prolific. Because the grantor is treated as the owner of the grantor trust for income tax purposes, she is responsible for the payment of the income taxes incurred by the trust. The payment by the grantor of the grantor trust's income taxes effectively allows the grantor to make additional tax-free gifts to the grantor trust and increases the grantor trust's rate of return. This can be a very powerful technique.

Sales and exchanges between the grantor and the grantor trust are also ignored for income tax purposes. Accordingly, it is very common for a grantor trust to purchase a business interest and/or other appreciating property from the grantor. Oftentimes, the purchase price is paid by making a 9-year interest only promissory note payable to the grantor (the "Sale Technique").

Since the grantor trust is not a separate taxpayer for income tax purposes, there is no recognition of gain on the sale, nor of interest income on the note. The interest rate on the note can be the lowest rate which will not cause adverse tax consequences. (This rate changes monthly and is currently 3.56% for June 2023.) If the interest sold to the grantor trust grows faster than the applicable interest rate, then the excess growth passes transfer-tax free to the grantor trust.

The Sale Technique has been replicated countless times since the release of Revenue Ruling 83-15, which supports the position that a sale of property from a grantor to a grantor trust is not a taxable event. This ruling has been the backbone of many modern estate planning techniques. If no gain is recognized on such a sale, the grantor trust takes a carryover basis in the grantor's property.

For example, if the grantor trust buys from the grantor shares in Company ABC with a basis of $50,000 for $1 million, the grantor trust's basis in the property is $50,000. But if, instead, the grantor held onto the shares of Company ABC, and if the shares were worth $1 million at death, the beneficiaries of the grantor's estate would inherit those shares with a basis of $1 million by virtue of Code Section 1014.

Many practitioners argued, before the release of Revenue Ruling 2023-2, that the assets of a grantor trust should be eligible for the Code Section 1014 basis step-up on the grantor's death. After years of hesitance to reckon with the issue, the IRS has finally confirmed that the assets of a grantor trust will not get a basis step-up to the date of death fair market value. Instead, the basis of assets held in a grantor trust will not be affected by the grantor's death. Thus, the gain on any sale of the grantor trust's assets will be calculated using the basis of such assets as it existed prior to the death of the grantor.

With this new certainty, how should estate planners be advising clients? Below are a handful of strategies that might be attractive to those clients who have incorporated irrevocable grantor trusts into their estate planning, but would like to be able to take advantage of the basis step-up on the death of the grantor:

•Power to Exchange Assets. Many grantor trusts vest the grantor with the right to substitute trust property for other assets of equivalent value (the "Substitution Power"). If a grantor trust contains an asset with a low basis, the grantor, during his or her lifetime, could exercise the Substitution Power and exchange the low basis asset for property with a higher basis, but of equal value (e.g., cash for stock). The low basis asset now has become a part of the grantor's estate, and if retained by the grantor until death, such asset will be eligible for the Code Section 1014 basis step-up.

•Second Sale to Trust. If the trust agreement establishing the grantor trust does not grant a Substitution Power, then the grantor could purchase low basis assets from the trust for high basis assets (e.g., cash for stock). The grantor may desire to engage in a series of sales to ensure appreciated stock continues to cycle back to the grantor so the estate can take advantage of the Code Section 1014 basis step-up.

•Granting a General Power of Appointment. In certain circumstances, it might be possible to grant a testamentary general power of appointment over a grantor trust to a parent or other elderly relative (the "Powerholder"). The grant of a general power of appointment results in the assets subject to such power being includable in the estate of the Powerholder for estate tax purposes. The trust assets includible in the Powerholder's estate will then be eligible for the Code Section 1014 basis step-up upon the death of the Powerholder. The grant of a general power of appointment should not exceed the Powerholder's available estate tax exemption and only apply to assets which have built-in gain. The planner will also need to consider the Powerholder's creditors and its risks to the grantor trust before considering this approach.

Revenue Ruling 2023-2 has confirmed the position of the IRS that completed gifts to grantor trusts are not eligible for a basis step-up under Section 1014 of the Code upon the death of the grantor. Nevertheless, the estate planning practitioner may be able to consider some of the techniques described in this article to help minimize capital gains ultimately payable on the sale of the grantor trust assets.