New IRS Rules Could Affect Your Children’s Inheritance

New IRS Rules Could Affect Your Children’s Inheritance

The Internal Revenue Service (IRS) plays a pivotal role in shaping how individuals and other entities manage their financial affairs. Experienced estate planning and tax lawyers need to stay fully informed about any rule changes that could impact the way a client’s assets are best structured to maximize value and minimize tax liability. At Ely J. Rosenzveig & Associates, we take our responsibility to know the latest rules very seriously.

On March 29, 2023, the IRS issued a new rule, Revenue Rule 2023-2, that has potential implications for the tax treatment of children whose parents intend to transfer assets to them through a grantor trust. This article explains the new rule and discusses its significance and its potential effects on both grantors and beneficiaries.

Understanding Grantor Trusts

To appreciate the impact of IRS Revenue Rule 2023-2, it’s crucial to understand the concept of grantor trusts. A grantor trust is a trust arrangement where the grantor – the person who establishes the trust – is also considered the owner for income and estate tax purposes. This means that the grantor’s income generated by the trust’s assets is reported on the grantor’s personal tax return, rather than being subject to taxation as a trust.

The reason for this income tax treatment goes back to how people used to use trusts to lower their income tax bracket. A trust is a legal entity separate from its grantor. High earning people used to spread their income-earning wealth among several smaller trusts, each of which was taxed separately and in a lower tax bracket than if all the income were counted together for tax purposes. The IRS eliminated that strategy by making the grantor trust a pass-through entity for income taxes.

A trust becomes a grantor trust by including terms that let the grantor retain control over the trust assets. This applies to all revocable trusts because they can be revoked during the grantor’s life and the grantor can regain ownership of the asset. A grantor retaining certain powers over the trust assets will determine that it is a grantor trust, including the following:

  • power to revoke,
  • power to substitute one trust asset with another asset of equal value,
  • power to change beneficiaries,
  • power to distribute income to the grantor or the grantor’s spouse.

While all revocable trusts are by definition grantor trusts (because they can be revoked), some irrevocable trusts can also acquire grantor trust status. Assets in irrevocable trusts are not typically considered part of the grantor’s estate when they die. Revocable trust assets are counted in the decedent’s estate. That is the crucial distinction between the two types of trusts’ different treatment under the new IRS rule.

Was the Trust Asset Gift to the Recipient Complete Before the Grantor’s Death?

The new IRS Rule 2023-2 spells out the IRS’s interpretation of the tax code as it applies to trust assets transferred to beneficiaries without being included in the trust grantor’s probate estate.

The new IRS Revenue Rule 2023-2 makes clear that only assets that are transferred by bequest, devise, or inheritance, or from the decedent’s estate will be entitled to the benefit of a “stepped-up” basis.

When a person’s wealth is so great that their estate may exceed the federal estate tax exemption level, they often create irrevocable trusts to transfer their assets to children and grandchildren without the assets being included as estate assets. Since the current estate tax exemption is $13.61 million, a limited number of people are concerned with this issue.

However, when an asset in an irrevocable trust increases in value, and then is received by the trust beneficiary without passing through the estate, the new IRS Rule will deny them the benefit of a “stepped-up basis.”

Why? Reading tax code 26 U.S. Code § 1014 literally, the IRS has decided that only assets that are received through bequest, devise, or inheritance, or from a decedent’s estate, are entitled to a stepped-up basis when sold by the recipient of the asset. When an irrevocable trust asset is gifted to a beneficiary and  is not included in the decedent’s estate, the gift will be deemed to have been completed at the time the trust was created.

The gifted asset was not “inherited” by way of the state’s laws of intestate succession. The gift was not “devised” as would be a piece of real estate given in a decedent’s last will. And the gift was not a “bequest,” such as an item of personal property bequeathed through a will.

Since the IRS considers the transfer of the asset from the grantor to the beneficiary to have been completed without any inheritance, devise, bequest, or through the decedent’s estate, the beneficiary is not entitled to use a stepped-up basis if they sell the asset.

What Does a “Stepped-Up Basis” Mean?

When a person inherits an asset following a grantor’s death, the recipient is typically permitted to value the asset at a “stepped-up” basis. That means that if the asset were acquired by the grantor when it had a value of $1,000 but the value had grown to $20,000 at the time of the grantor’s death, the person who received the inheritance would not have to pay capital gains tax on the $19,000 profit. Specifically, if the heir or devisee sells the asset in the aftermath, the cost basis of the asset (what the asset cost the seller) enjoys a step-up in valuation equal to the fair market value of the asset at the time of the decedent’s death.

If the actual basis of the asset ($1,000) were used in the equation instead of the “stepped-up” basis ($20,000), the person who received the asset would owe capital gains taxes on the $19,000 difference in value when they sold it. Instead, the asset’s stepped-up cost basis on death of $20,000 would be applied against the proceeds on sale of the asset in the calculation of the applicable capital gains tax.

The new IRS Revenue Rule 2023-2 makes clear that only assets that are transferred by bequest, devise, or inheritance, or from the decedent’s estate will be entitled to the benefit of a “stepped-up” basis.

Consult with an Experienced Estate Planning Attorney to Learn More

The complexities of different trusts and their respective tax treatment is the focus of estate planning attorneys who draft and handle legal matters involving trusts and estate issues every day.

After decades of experience practicing in this field, the trust & estate lawyers at Ely J. Rosenzveig & Associates are well equipped to counsel you in all aspects  of your estate and tax planning. We will explore together what  strategy best reflects your wishes, fits your financial circumstances, and squarely meets your family’s needs.

Let Ely J. Rosenzveig & Associates guide you through the decision-making process to achieve your most effective estate plan.
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Ely J Rosenzveig
Ely Rosenzveig

Ely J. Rosenzveig practices principally in the fields of elder law, trusts & estates, tax planning, employment law, and mediation. He has extensive experience in federal and New York State tax law, and has successfully represented a wide range of clients on FBAR & FATCA compliance issues. Ely also practices employment law, with a particular emphasis on age and disability discrimination, negotiating compensation agreements, and severance issues. With his extensive background in the law, his experience as a congregational rabbi, and his specialized training in Mediation at Harvard Law School, Ely is also available as a professional mediator to help facilitate optimal solutions in matters ranging from family and estate disputes to multi-party commercial issues.

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