IRS Guidance On Irrevocable Trusts May Force Re-think – Law Firm

Editorial Staff

5 May 2023

Recent Internal Revenue Service guidance on how irrevocable trusts in the US should operate means that taxpayers with such trusts may have to re-think their income tax planning and look at new options in certain cases, according to Baker McKenzie.

In Revenue Ruling 2023-2, the IRS described a US citizen settlor who settled an irrevocable trust and was treated as its owner for income tax purposes, but did not possess any power to cause the trust to be includible in their gross estate. At the time of their passing, the trust asset had appreciated in value with a liability less than its basis. However, the trust property did not meet any of the enumerated criteria for a basis adjustment. The ruling focused on whether the trust property was acquired by bequest, devise, or inheritance, or whether the trust property was includible in the decedent's gross estate for US federal estate tax purposes.

The position highlights how complicated US trust law comes under a spotlight at a time when HNW US taxpayers could face lower exemptions on estate taxes when existing thresholds expire in 2025. Already, FWR has been told that firms are advising clients on tax mitigation and planning strategies.

In its note on the matter, Baker Mckenzie said the IRS argued that the property was not acquired by bequest, devise or inheritance because it was transferred as a completed gift to the irrevocable trust before the decedent's death rather than by will or under the laws of intestacy upon or after death. As a result, the trust would not be included in determining the value of the gross estate for US federal estate tax purposes. Thus, the IRS held that the trust property was not eligible for a basis adjustment upon the settlor's death.

“In most cases, a US taxpayer's capital gains upon the sale of an asset will be calculated by subtracting the basis of the asset from the sales price. If a US taxpayer receives an asset as a gift, the asset's basis remains the same as when it was held by the donor,” the law firm’s note said. “However, the basis of an asset that is considered to have been acquired from or to have passed from a decedent will actually be adjusted to its fair market value on the date of the decedent's death.”

“Making a completed gift to an irrevocable trust while retaining limited powers that would cause the trust to be treated as a grantor trust but not cause the trust assets to be includible in the grantor's estate is a common US estate tax planning technique,” it continued.

The US government indicated its intention to issue guidance on this topic in the past and recently did so by issuing Revenue Ruling 2023-2. It held that the assets in an irrevocable grantor trust do not receive a basis adjustment upon the grantor's death if the assets do not meet the requirements to be considered to have been acquired from or to have passed from a decedent and are not otherwise subject to US federal estate tax.