Under current law, assets acquired from a decedent receive an adjustment in cost basis to fair market value, thereby potentially eliminating significant unrealized gain. Although Congress has and likely will use this tax benefit as a pawn in future tax legislation, under current law, this benefit remains available to taxpayers. With respect to assets held in trusts excluded from estate tax, the IRS recently released guidance shutting the door on the application of this generous tax treatment to such assets.
Section 1014(a)(1) of the Internal Revenue Code of 1986, as amended (the “Code”) provides that “. . . the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be (1) the fair market value of the property at the date of the decedent’s death . . . .” But does this Code section apply to assets that are held in an irrevocable trust that is not subject to estate tax upon the settlor or donor’s death, when the settlor of the trust is treated as the owner of the assets for income tax purposes during his or her lifetime?
Before addressing, it is important to understand how irrevocable trusts are classified for U.S. income tax purposes—as either “grantor trusts” or “non-grantor trusts.” When an irrevocable trust is classified as a grantor trust, the trust is treated as identical to the settlor (i.e., the settlor is treated as the “owner” of the trust property for income tax purposes), requiring the settlor during his or her lifetime to report all matters of income and deduction with respect to the trust on his or her own individual income tax returns. Although the settlor of a grantor trust is treated as the owner of the trust property for income tax purposes, if the trust is structured correctly, the trust property will not be subject to estate tax inclusion in the settlor’s estate at death. When an irrevocable trust is classified as a non-grantor trust, the trust is deemed to be a separate taxpayer, requiring the trustees to file annual income tax returns for the trust (known as fiduciary income tax returns) reporting all matters of income and deduction with respect to the trust. Generally, whether an irrevocable trust will be classified as a grantor or non-grantor trust depends on certain powers that may have been retained by the settlor with respect to the trust, who are the beneficiaries of the trust, and certain provisions in the trust agreement.
Since Section 1014 of the Code does not specifically impose a requirement that assets be subject to estate tax inclusion in the settlor’s estate to receive Section 1014 treatment, until recently, some practitioners took the position that the assets held in a grantor trust (which were not otherwise subject to estate tax inclusion in the settlor’s estate) upon the death of the settlor automatically received a step-up in cost basis under such Section of the Code since the assets were technically acquired from a decedent. The IRS recently released guidance striking down this position.
In Revenue Ruling 2023-2, the facts before the IRS were as follows: “[i]n Year 1, A, an individual, established irrevocable trust, T, and funded T with Asset in a transfer that was a completed gift for gift tax purposes. A retained a power over T that causes A to be treated as the owner of T for income tax purposes under subpart E of part I of subchapter J of chapter 1 (subpart E). A did not hold a power over T that would result in the inclusion of T’s assets in A’s gross estate under the provisions of chapter 11. By the time of A’s death in Year 7, the fair market value . . . of Asset had appreciated. At A’s death, the liabilities of T did not exceed the basis of the assets in T, and neither T nor A held a note on which the other was the obligor.”
The taxpayer took the position that, although the assets of T were not subject to inclusion in A’s estate for estate tax purposes, the assets received a step-up in cost basis as a result of A’s death. The IRS, striking down this position, held that “[i]f A funds T with Asset in a transaction that is a completed gift for gift tax purposes [and the assets of T are not subject to inclusion in A’s gross estate for purposes of chapter 11], the basis of Asset is not adjusted to its fair market value on the date of A’s death under § 1014 because Asset was not acquired or passed from a decedent as defined in § 1014(b). Accordingly, under this revenue ruling’s facts, the basis of Asset immediately after A’s death is the same as the basis of Asset immediately prior to A’s death.”
This Revenue Ruling does not, however, leave taxpayers without recourse when a grantor trust holds low basis assets. One of the most common powers retained by a settlor that causes an irrevocable trust to be deemed a grantor trust for U.S. income tax purposes is the power of substitution. A power of substitution provides the settlor (or some other third party) acting in a non-fiduciary capacity with the ability to swap assets out of the trust for assets of equivalent value. For example, if A transfers 100 shares of X stock to a trust, which has a current fair market value of $500,000, A could swap the shares out of the trust for $500,000 of cash (or other property of equivalent value).
The power of substitution is a tool that can be used to move low basis assets back into the settlor’s estate to ensure such assets receive a step-up in cost basis upon the settlor’s death. For instance, in the example above, assume that the 100 shares of X stock had a fair market value of $100,000 at the time A transferred the shares to the trust and now, the shares have appreciated wherein the fair market value of the 100 shares is $500,000. The trust has $400,000 of unrealized gain and, under Revenue Ruling 2023-2, the shares will not receive a step-up in basis at the time of A’s death. As A approaches death, if A has sufficient liquidity to swap the shares out of the trust with assets with a higher basis (such as cash, which has a cost basis equal to its face value), A could use the power of substitution to swap the shares out of the trust for such other assets. By swapping the stock out of the trust, at the time of A’s death, the shares will now receive a step-up in cost basis, thereby eliminating the unrealized gain of $400,000 that the trust would have otherwise realized if the stock had been sold by the trust.
Accordingly, although the IRS’s ruling has confirmed that the assets held in a grantor trust do not automatically receive a step-up in cost basis upon the death of the settlor, there are other available planning opportunities that can be deployed to eliminate unrealized gain held by a grantor trust. As such, as individuals advance in age and approach death, it is always advantageous to work with tax and estate planning counsel to review possible options to ensure that assets pass in the most tax-efficient manner upon death.
 Under Section 675(4) of the Code, if a power of administration (such as a power of substitution) is exercisable by an individual (either the settlor or some other third party) in a non-fiduciary capacity without the approval or consent of any person in a fiduciary capacity, the trust will be deemed a grantor trust.