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In the last few decades, more and more U.S. families have been utilizing irrevocable trusts as part of their estate planning in order to protect their assets and manage their taxes in an efficient manner. Generally, assets that are sold or redeemed during an individual’s lifetime are subject to capital gains taxes on the increase in value over time. The amount of capital gains tax that is owed is largely based upon the difference between the price paid for an asset plus certain investments over time, which increase the “cost basis” and the value of the same asset at the time of disposal.

An exception to these capital gains taxes occurs when assets that would otherwise normally be subject to such taxes pass by virtue of the death of the owner to their inheriting beneficiaries. When beneficiaries inherit an asset with unrealized capital gains at the time of the asset owner’s death, the recipient of such asset generally receives a “step-up” in cost basis, meaning the recipient inherits the asset as if it had been purchased at the present-day fair market value and not the value at the time the asset was purchased in the past by the decedent.

On the other hand, in the interest of estate tax planning or a desire to make significant lifetime gifts to their heirs, many taxpayers decide to transfer some of their assets into an “irrevocable trust.” As a result, in many cases the taxpayer gives up all ownership or rights to those assets and the trust instead becomes the owner, effectively removing the assets from the grantor’s taxable estate. This gift, therefore, might yield a beneficial result from an estate tax perspective by removing those assets (and their future income and appreciation) from the taxable estate, but the outcome from a capital gains tax perspective is more complicated.

If the taxpayer makes a completed gift of assets and retains no benefit or control over them, it has been generally accepted that this results in the recipient of the assets receiving a “carry-over” cost basis, or in other words, the same basis that the grantor taxpayer had in those assets. However, some tax professionals have taken the position that completed gifts to certain irrevocable trusts could allow the taxpayer’s family to have their cake and eat it too, by excluding those assets from the decedent’s taxable estate for estate tax purposes and also receiving a step-up in cost basis upon the trust grantor’s death.

However, in March 2023, the IRS put an end to any speculation when they issued Revenue Ruling 2023-2, which unequivocally clarified the rules for individuals looking to avoid tax liability for previously unrealized capital gains. The ruling confirms that assets held in irrevocable trusts, which are included in the taxpayer’s estate at the time of the death, certainly do get a step-up in basis. This type of arrangement is common in irrevocable trusts established for Medicaid planning purposes where the grantor retains a life estate in real estate held in the trust and/or an income right in assets transferred into trusts. Estate taxes are typically not of concern in Medicaid planning scenarios, and accordingly those taxpayers and their heirs can still rely on the idea that the trust assets should still receive a step-up in cost basis. However, any assets held in an irrevocable trust which are not included in the grantor’s taxable estate at the time of death would result in a “carry-over” cost basis for the trust and its beneficiaries.

The good news is that most American citizens and permanent residents will not find themselves subject to estate tax right now due to the current $12.92 million per person exclusion for 2023, and $25.84 million total exclusion for married couples. To put the number of Americans impacted by the federal estate tax into perspective, in 2001 when the estate tax exemption was $675,000, approximately 108,000 estates were required to file estate tax returns, with 48,492 of them (44.9%) being required to pay taxes. By contrast, in 2021, 6,158 estates were required to file estate tax returns, but only 2,584 of them (42%) were required to pay any tax at all. However, the changes made by Revenue Ruling 2023-2 are likely to impact more families and individuals in 2026 when the Tax Cuts and Jobs Act sunsets on December 31, 2025, returning the federal estate tax exemption to $5 million per individual, adjusted for inflation.

For those higher net-worth clients engaged in estate tax planning, this ruling puts an end to the idea that they can gift property to an irrevocable trust, reduce their taxable estate AND have their heirs enjoy a cost basis step-up. However, this was an accepted reality by most tax professionals long before this ruling. In a nutshell, estate tax planning remains a cost/benefit analysis where estate tax reduction is on one side of the scale, and favorable basis adjustments are on the other. This is why planners typically prefer transferring higher basis assets to these types of trusts, and in an ideal world, keeping the low or zero cost basis included in the decedent’s taxable estate to attain a step-up. Often the fact that federal estate tax is generally a punitive 40% cost upon death and capital gains are typically 20% or less on the gain and only triggered upon sale, tilts the table in favor of saving on estate taxes and forgoing the basis step up, but this is not always the case! The only way to know for sure is to have your estate attorneys and/or accountants analyze your specific circumstances.

Regarding irrevocable trusts set up for Medicaid qualifying reasons; the objectives and tax outcomes are obviously quite different. As the average lifespan of Americans is increasing, more and more individuals are finding themselves in need of long-term healthcare that could consume a large portion of the assets they had anticipated leaving behind for their heirs. Irrevocable trusts are a valuable planning tool wherein an individual can transfer assets, such as their home, and within a period of time remove that asset from being considered an available resource to be used on the cost of their care. This is generally preferred to making outright gifts to children, as a certain level of accountability and control is preserved, and the assets transferred to the trust should not be vulnerable to the children’s disgruntled ex-spouses or creditors. Of course, in either case the parent(s) will want to reserve a life estate in that house, or a right to income from other assets transferred to the trust, in order to ensure that they will be able to remain in the house undisturbed for the rest of their life.

The key part of Revenue Ruling 2023-2 is that only those assets that are held in an irrevocable trust that are NOT otherwise included in a grantor’s estate at the time of their death for estate tax purposes will lose the step-up in basis. The very presence of this life estate or income right in the property means that the trust’s assets will be included as part of the grantor’s taxable estate upon death and therefore will receive a cost basis step-up. As previously mentioned, this type of planning means that these assets would be subject to estate taxes IF the grantor’s estate exceeds the applicable estate tax exemptions, but we’ve already established that those exemptions are quite high and typically not of concern to taxpayers engaging in Medicaid planning. This highlights the importance of making sure that these irrevocable trusts are properly drafted and structured.

In summary, not all hope for irrevocable trusts is lost. In fact, for most taxpayers and their advisors Revenue Ruling 2023-2 does not meaningfully change the cost/benefit analysis. As always, careful and precise planning will need to be executed moving forward. It is of the utmost importance to understand that any trust holding assets which are included in the grantor’s taxable estate at death should receive a cost basis step-up upon the grantor’s death, and conversely where those assets are not includable in the grantor’s taxable estate no basis adjustment will normally occur.

If you are thinking about using an irrevocable trust as part of your estate plan, it is best to consult with a trust and estates attorney or other qualified tax professional in order to make sure your trust not only complies with the updated IRS rules but also takes into account the choice between estate tax savings and capital gains considerations upon inheritance by your children or other designated beneficiaries.

For more information on the topic discussed, contact:

• Jordana E. Balsam  |  balsam@thsh.com  |  212-508-6798
• Yolanda Kanes  |  kanes@thsh.com  |  212-508-6721
• Jordan S. Linn  |  linn@thsh.com  |  212-508-6724