Revenue Ruling 2023-2, issued in March 2023, made a major change to how assets in irrevocable trusts are treated. The rule states those assets in an irrevocable trust that are not included in the grantor’s taxable estate cannot receive a step-up in basis. This means the trust’s beneficiaries may inherit assets with the grantor’s original purchase price rather than the fair market value at the time of the grantor’s death. They thus may find that they will have to pay significant capital gains tax when they sell the assets.

Irrevocable trusts hold assets and property for the benefit of designated beneficiaries. Unlike revocable trusts, which can be amended during the grantor’s lifetime, assets that are transferred to an irrevocable trust cannot be removed. Irrevocable trusts generally are used in an estate plan because (1) irrevocable trusts protect assets from the spend-down requirements of government benefits (e.g., Medicaid) and (2) income generated by the trust’s assets and distributions made to the beneficiaries are not subject to estate taxes (though they may be subject to income tax). Additionally, assets placed in an irrevocable trust reduce the value of the estate for estate tax purposes.

What does this mean for you?

Historically, when assets in an irrevocable trust are passed to the beneficiaries at the grantor’s death, the beneficiaries receive them on a stepped-up basis. That is the trust’s assets were not valued with the grantor’s purchase price but were instead valued with the fair market value on the date of the grantor’s death. By inheriting assets with this basis, beneficiaries were subject to no or greatly reduced capital gains taxes.

Revenue Ruling 2023-2 changed that calculation in a way that may significantly increase the beneficiaries’ capital gains tax. However, if the trust is worded so that the trust’s assets are included in the grantor’s taxable estate, the tax burden may be reduced.

Here’s an example of the impact of Revenue Ruling 2023-2.

In 2019, Roy transferred both his primary residence and a second home into an irrevocable trust, naming his only child, Toby, as the beneficiary. The trust was structured so that the properties were not included in Roy’s taxable estate. Roy passed away on Jan. 7, 2024. Here are the tax outcomes Toby faces:

1. Primary residence: Roy purchased his primary home in 1989 for $325,000. On Jan. 7, 2024, the home’s fair market value was $499,000. Since the home was Roy’s primary residence and qualifies for the $500,000 exclusion from capital gains for a married couple, no capital gains taxes would be due if the property is sold at this value or below.
2. Second home: Roy purchased the second home in 2020 for $250,000, and its fair market value at the time of his death was $350,000. Under Revenue Ruling 2023-2, because the trust’s assets were not included in Roy’s taxable estate, Toby inherits the property with the original cost of $250,000. If Toby sells the home for its fair market value of $350,000, he will owe capital gains tax on the $100,000 gain.

Can an irrevocable trust be changed?

Under certain circumstances, it may be possible to change the terms of an irrevocable trust. Two potentially acceptable reasons for doing so are (1) to change the trustee and (2) to provide for a special needs trust. However, state laws vary, and some allow modifications with beneficiary consent or through so-called decanting statutes that allow the trustee to move assets to another trust.

Here are the steps that must be taken to determine whether the trust terms can be changed:

• Step 1: Read and understand the terms in the existing trust document.
• Step 2: Review state law to determine whether the trust can be modified, perhaps through the courts, if all the beneficiaries agree. Note that the rules regarding irrevocable trusts are very restrictive.
• Step 3: Understand the tax consequences of the changes being considered. Federal and/or state income taxes may be triggered when changes are made to estate planning documents. Gift taxes, although generally not a factor, may come into play if a new trust is created that changes the interests of the beneficiaries. Most estates are not large enough to be subject to estate taxes; currently, only estates exceeding $13.61 million ($25.84 million for married couples) are subject to the estate tax.

It is essential to regularly review your estate plan to understand how tax laws impact the assets in your trust and the potential tax burden on your beneficiaries. For example, if your goal is to minimize taxes through the step-up in basis, you may need to adjust your trust. Revising the trust to include its assets in the taxable estate may restore this benefit.

Tax law changes, such as the one discussed here, make it a good idea to meet with a tax professional periodically to review your estate plan. Even if your estate plan includes an irrevocable plan that cannot be amended, there may be other ways to protect beneficiaries from having to pay a big tax bill.