Changes to Tax Laws and Irrevocable Trusts

In March 2023, the IRS issued Revenue Ruling 2023-2, which introduced a significant alteration in the way assets in irrevocable trusts are handled for tax purposes. According to the new rule, assets placed in an irrevocable trust that are excluded from the grantor’s taxable estate will no longer be eligible for a step-up in basis. As a result, beneficiaries inheriting those assets will receive them at the grantor’s original purchase price rather than at their fair market value at the time of the grantor’s death. This could lead to substantial capital gains taxes when the beneficiaries eventually sell those assets.

Irrevocable trusts are legal tools used to hold assets for the benefit of designated beneficiaries. Unlike revocable trusts, which can be altered during the grantor’s lifetime, the assets in an irrevocable trust cannot be reclaimed or changed once transferred. These trusts are frequently utilized in estate planning for two main reasons: (1) they help shield assets from the spend-down rules for government benefits like Medicaid, and (2) income from the trust and distributions to beneficiaries are generally not subject to estate taxes, although they might be taxed as income. Furthermore, placing assets in an irrevocable trust can reduce the value of the estate for estate tax purposes.

What Does This Mean for You?

In the past, when assets in an irrevocable trust were passed to beneficiaries after the grantor’s death, they typically received a “stepped-up” basis. This meant that the assets were valued based on their fair market value on the date of the grantor’s death, not their original purchase price. This step-up in basis helped minimize capital gains taxes for the beneficiaries if they sold the assets.

With the new Revenue Ruling 2023-2, however, that process has changed. The ruling indicates that if the assets in an irrevocable trust are excluded from the grantor’s taxable estate, they will not be eligible for a step-up in basis. As a result, beneficiaries may face significantly higher capital gains taxes. However, if the trust is structured so that its assets are included in the grantor’s taxable estate, the beneficiaries may still benefit from the step-up in basis, potentially lowering the tax burden.

Example of the Impact of Revenue Ruling 2023-2

To illustrate the potential impact, consider the case of Roy, who transferred his primary residence and a vacation home into an irrevocable trust in 2019. Roy named his son, Toby, as the beneficiary, and structured the trust so that the properties would not be included in his taxable estate. Roy passed away on January 7, 2024. Here’s how Toby would be affected by the new rule:

• Primary Residence: Roy bought his primary home in 1989 for $325,000. At the time of his death, the home’s fair market value was $499,000. Because the home qualifies for the $500,000 exclusion for capital gains taxes on a married couple’s primary residence, Toby would not owe any capital gains tax if the home is sold at or below its fair market value.

• Second Home: Roy purchased the second home in 2020 for $250,000, and it was worth $350,000 when he passed away. Since the second home was not included in Roy’s taxable estate, Revenue Ruling 2023-2 requires that Toby inherit the property at its original purchase price of $250,000. If Toby sells the property for $350,000, he would owe capital gains tax on the $100,000 profit.

Can an Irrevocable Trust Be Changed?

Although irrevocable trusts are designed to be permanent, in some cases, they can be modified. For instance, changes to the trustee or the inclusion of a special needs trust may be permissible. However, state laws differ, and some allow modifications if all beneficiaries agree or if decanting statutes are in place, which enable the trustee to transfer assets into a new trust.

Here’s how you can assess whether an irrevocable trust can be modified:

Step 1: Review the terms of the trust document carefully.

Step 2: Investigate local state laws to determine if trust modifications are possible, either by court approval or beneficiary consent.

Step 3: Understand the potential tax consequences. Changes could trigger federal and/or state income taxes, and there might be gift tax implications if a new trust alters the beneficiaries’ interests. Although most estates are not large enough to be subject to estate taxes, estates exceeding $13.61 million ($25.84 million for married couples) are subject to estate tax.

Regularly reviewing your estate plan is crucial to understanding how tax law changes could affect the assets within your trust. If reducing taxes through a step-up in basis is a key objective, you may need to adjust your trust to ensure that its assets are included in your taxable estate, thereby restoring the step-up benefit.

Conclusion

Given ongoing changes in tax law, including the update discussed here, it is wise to meet with a tax professional to review your estate plan periodically. Even if your trust is irrevocable and cannot be amended, there are often other strategies that can help mitigate the potential tax burden on your beneficiaries.