One of the best ways to plan for your future is to create an estate plan. An estate plan can help you secure your assets and provide for your family and loved ones after you’re gone. You should set up your estate plan as early in your adult life as you can and update it whenever your life changes enough to warrant it or if there is a law or rule change that requires it.
Recently, the IRS implemented a rule change that may further complicate matters when it comes to estate plans, irrevocable trusts, and taxes. Specifically, this change affects how the step-up in basis is applied to assets held in an irrevocable trust.
In this blog post, we'll review what an irrevocable trust is, what part it can play in an estate plan, and how this IRS rule change could impact your irrevocable trust, taxes, and estate plan.
What Is an Irrevocable Trust?
Estate planners often recommend using trusts to manage and direct assets as part of an estate plan. One such trust option is an irrevocable trust.
An irrevocable trust is a legal entity created to hold assets and is separate from the person who created it. This trust is irrevocable, which means that the person who creates the trust cannot change or revoke it without the beneficiaries' (people who it was created for) permission. Once created, the assets in an irrevocable trust are no longer part of the creator's taxable estate. This can reduce estate taxes and may help with Medicaid planning.
There are several advantages to creating an irrevocable trust, including:
- Provides Asset Protection: An irrevocable trust offers protection to your assets from creditors, divorce settlements, legal judgments, or any other legal claims.
- Minimizes Estate Taxes: Irrevocable trusts help minimize or eliminate estate taxes, which are federal or state taxes levied on property transferred upon death.
- Prevents Family Disputes: Irrevocable trusts can help prevent disputes among beneficiaries or heirs over assets, as the creator can set specific terms, conditions, and timelines for the distribution of assets.
- Offers Greater Financial Control: With an irrevocable trust, the creator can specify how the assets will be distributed, to whom, and under what circumstances after the creator's death the assets are to be distributed.
- Can Help with Medicaid Planning: Creating an irrevocable trust can help protect assets while meeting the Medicaid eligibility criteria for long-term care.
Below are some of the most common types of irrevocable trusts:
- Irrevocable Life Insurance Trust (ILIT): This type of trust is created to own a life insurance policy. The proceeds of the policy can remain outside the taxable estate and can provide liquidity to the estate.
- Grantor Retained Annuity Trust (GRAT): A GRAT is created to transfer assets to family members while minimizing estate taxes. The creator of the trust receives annual payments in exchange for the gift.
- Medicaid Trust: This type of irrevocable trust helps seniors transfer and protect their assets while still meeting Medicaid eligibility requirements for long-term care.
What’s a Step-Up in Basis?
If a person inherits an asset with unrealized capital gains, the basis of the asset is adjusted to the current fair market value. This adjustment, also known as "stepping up" the basis, eliminates any tax liability for previously unrealized gains.
Here's an example to illustrate this concept: Let's say you bought some stock over a year ago for $150,000 and now you sell it for $350,000. You would normally owe capital gains tax on the $200,000 profit above the original basis. However, if you inherit that stock, your new basis "steps up" to $350,000. This means you'll only be subject to tax if you sell the stock for more than that amount.
To safeguard their assets, some individuals choose to transfer them into an irrevocable trust. By doing so, they relinquish ownership rights, and instead, the trust becomes the owner of the assets for the benefit of its beneficiaries.
How Does This New IRS Ruling Impact Step-Up in Basis for Irrevocable Trusts?
The IRS recently released revenue ruling 2023-2, which significantly changes the basis adjustment pursuant to section 1014 involving the assets of an irrevocable grantor trust.
Section 1014 provides that the basis of property being held in trust from a decedent if not sold or exchanged prior to the death of the decedent will bear the fair market value of the property at the date of the decedent’s death. However, this new revenue ruling has determined that the basis of “step-up” capital treatment pursuant to section 1014 does not apply to assets gifted to an irrevocable grantor trust.
This is significant because traditionally the notion had been that such assets held in such irrevocable trusts would be accorded a stepped-up basis so that the capital gains due upon the sale of such property would be determined by the value of the property at the date of the decedent’s death. That is no longer the case. This could result in recipients of trust benefits facing two very significant capital gains treatments.
What Should I Do if I Have an Irrevocable Trust?
If you have an irrevocable trust, it's important to review your estate plan and ensure that it aligns with the IRS’s latest rulings. You should also speak with an experienced estate planning attorney about the situation and determine if there are any changes you can make to your trust that will allow you to preserve the step-up in basis for assets that will be inherited by your heirs.
Questions about IRS rule changes concerning estate plans, irrevocable trusts, and taxes? Call Cantafio & Song PLLC at (888) 458-0991 or reach out to us online today to schedule a free personalized consultation with our experienced estate planning, wills, and trusts attorneys in Colorado.