Taxes

Revenue Ruling 2023-2 Got It Wrong? The Case For A Stepped-Up Basis When The Grantor Dies

A short grantor trust walks into a bar. After a few too many drinks he starts flirting with a pretty beneficiary, promising her a step up in his assets. But before he seals the deal, the bartender pulls the stool out from under him, shouting, “Get out! You’ve got no basis stepping up here.”

“Based upon the detailed discussion that follows, we have concluded that there is a solid argument that there is a basis adjustment to the fair market value of the assets of a grantor trust on the death of the grantor.”

EXECUTIVE SUMMARY:

It is the duty of a tax professional to advise and educate clients so that clients can make informed and intelligent decisions. We believe that reasonable professionals, courts, and appellate courts can disagree on the question of whether there is a step-up in basis on the death of the grantor for assets that are not included in the Grantor’s gross estate for estate tax purposes but are owned by the Grantor for income tax purposes. Eventually this issue will be decided by courts. Until then, advisors are taking some degree of risk if they tell clients that there is no adjustment in basis on the death of the grantor. Courts may determine that there is a basis adjustment based on our analysis below.

A Revenue Ruling is binding on the IRS and can be relied upon by any taxpayer, but a Revenue Ruling does not have the same impact as a law or a Tax Court or appellate decision.

Revenue Rulings are not binding on any federal court, including the Tax Court.[1] While most courts give deference to Revenue Rulings, the Tax Court does not give particular weight to Revenue Rulings because they are considered to represent the arguments of one of the parties before the court.[2]

Our analysis in the Comment section was largely prepared before the IRS issued a Revenue Ruling on this issue. Now that Revenue Ruling 2023-2 has been issued, we do not believe that the IRS’s position is beyond question. Although there is the risk of penalty, a taxpayer might consider paying the capital gains tax on the tax return as if the assets did not receive an adjustment in basis, and then filing an amended tax return requesting a refund based on the assets receiving a step-up in basis, and providing full disclosure that this position was taken. Then, if the step-up in basis is denied, the taxpayer did not make a substantial underpayment on the original return, and the risk of penalties being incurred by the taxpayer should be greatly reduced.

There will doubtlessly be many other articles that describe what the ruling says and argue that there is no adjustment in basis for these assets in this situation. In our opinion, there will likely be too few articles on why there should be an adjustment in basis on the death of the grantor.

FACTS:

The Treasury Department issued Revenue Ruling 2023-2 on March 29, 2023. The ruling held that assets owned by an irrevocable grantor trust should not receive an adjustment in basis on the death of the grantor, because the Trust’s assets were not acquired from or were not passed from the decedent to the beneficiary for purposes of IRC § 1014(a).

The facts presented in the Revenue Ruling were as follows:

In Year 1, A, an individual, established irrevocable trust, T, and funded T with Asset in a transfer that was a completed gift for gift tax purposes. A retained a power over T that causes A to be treated as the owner of T for income tax purposes . . . . A did not hold a power over T that would result in the inclusion of T’s assets in A’s gross estate . . . . By the time of A’s death in Year 7, the fair market value (FMV) of Asset had appreciated. At A’s death, the liabilities of T did not exceed the basis of the assets in T, and neither T nor A held a note on which the other was the obligor.

IRC § 1014(b) defines the type of property that is entitled to this adjustment in basis at a decedent’s death.[3] The Revenue Ruling held that none of the seven property types apply to the property owned by an irrevocable grantor trust upon the death of the grantor.

The IRS states in the Revenue Ruling that such assets are not bequeathed (“giving property[,] usually personal property or money[,] by will”), devised (“giving property, especially real property, by will”), or inherited (“received from an ancestor under the laws of intestacy or property that a person receives by bequest or devise”) (Section 1014(b)(1) property). The grantor did not retain a power to revoke or amend the trust, and did not hold a power of appointment over the trust asset (Sections 1014(b)(2), (3), and (4) property). The asset was not community property (Section 1014(b)(5) property) and it is not included in the grantor’s gross estate (Section 1014(b)(6) and (7) property).

In essence, because transfers to an irrevocable trust are “completed gifts” at the time of the transfer, when the grantor does not hold a beneficial interest in or a retained power over the Trust property (certain decision-making provisions that would require the trust asset to be included in the grantor’s gross estate), the Revenue Ruling concludes that the beneficiary is not “inheriting” these assets from the grantor on the grantor’s death. Rather, the beneficiary is receiving the assets from the trust, which does not constitute assets being “bequeathed” or “devised” by the grantor on the grantor’s death. Therefore, the Revenue Ruling indicates that the assets held under the trust do not receive a basis adjustment, and the beneficiary carries over the decedent’s basis in the assets.

COMMENT:

Based upon the detailed discussion that follows, we have concluded that there is a solid argument that there is a basis adjustment to the fair market value of the assets of a grantor trust on the death of the grantor. As a result of this, we feel that it is appropriate to report income from any sale of the assets owned by a grantor trust based upon a fair market value date of death income tax basis for the applicable assets. The IRS and most tax commentators disagree with our conclusion, but we believe that this conclusion can be reached by the Tax Court or an appellate court, notwithstanding Revenue Ruling 2023-2.

Unfortunately for taxpayers and practitioners who represent them, many questions exist in the tax law. One of these questions is whether the assets of a grantor trust receive an adjustment in basis on the death of the grantor, even though the assets of the trust are outside of the grantor’s gross estate.

When a tax position is unsuccessfully taken on an income tax return, there are penalties and interest that can apply, which can be mitigated if there is what is known as “Substantial Authority” for the position taken. Substantial Authority and what is known as the “Understatement Preparer Penalty” rules are further discussed in this Comment.

Now that the IRS has issued a Revenue Ruling on the issue, it may attempt to apply penalties on audit, claiming that there is no Substantial Authority for the position that an adjustment in basis occurred at the time of the death of the grantor of a trust, although we do not believe this to be the case. In the event that additional tax is owed, the taxpayer will have to pay interest on the amount owed because the interest requirement for underpayments is statutory and cannot be waived by the Internal Revenue Service.

Grantor trusts have been used by practitioners for years as an estate planning tool to help shift wealth to subsequent generations. A typical grantor trust is an irrevocable trust which has been designed so that it is not included in the gross estate of the grantor for the purposes of determining the size of the grantor’s gross estate and the grantor’s possible estate tax exposure. The grantor retains specific powers over the grantor trust so that the grantor trust is considered to be owned by the grantor for income tax purposes.

Prior to Revenue Ruling 2023-2, there was a common misconception (in our opinion) among practitioners that the tax law and IRS rules were clear that the assets of a grantor trust would not receive an adjustment in basis under Section 1014 on the death of the grantor, because the assets of the grantor trust were not included in the grantor’s gross estate.

The IRS issued Revenue Procedure 2022-3 on January 3, 2022. The Revenue Procedure listed areas of domestic tax law on which the IRS would not issue rulings or determination letters.

Section 5 of the Revenue Procedure was creatively entitled “Areas Under Study In Which Rulings or Determination Letters Will Not Be Issued Until the Service Resolves the Issue Through Publication of a Revenue Ruling, a Revenue Procedure, Regulations, or Otherwise.” Item 11 of this Section specifically applied to the basis of a grantor trust after the death of the grantor, and provided as follows:

Section 1014 – Basis of Property Acquired from a Decedent – Whether the assets in a Grantor Trust received a Section 1014 basis adjustment at the death of the deemed owner of the trust for income tax purposes when those assets are not includible in the gross estate of that owner under chapter 11 of subtitle B of the Internal Revenue Code.

The fact that this issue was an area under study in which Private Letter Rulings would not be issued to taxpayers, demonstrated that the IRS attorneys had not determined if there is an adjustment in basis to the assets of the grantor trust on the death of the grantor. With Revenue Ruling 2023-2, the IRS has now taken a position on the issue, but there remains contrary authority and arguments that can be used by the Tax Court, the Court of Claims, and an appellate court in reaching the opposite conclusion.

In September of 2002, tax law luminaries Jonathan G. Blattmachr, Prof. Mitchell M. Gans, and Hugh H. Jacobsen published an article entitled “Income Tax Effects of Termination of Grantor Trust Status By Reason of the Grantor’s Death” in the September 2002 edition of the Journal of Taxation. The article states that there is no clear answer as to what the basis of the grantor trust assets would be on the death of the grantor. Jonathan Blattmachr is one of the most well-respected tax lawyers in the United States, and Mitchell Gans is a well-respected Tax Professor who publishes extensively, and who also has also provided training courses for IRS personnel for many years.

The authors noted that Section 1014(b)(9) requires grantor trust assets to be included in the estate of the grantor to receive a basis adjustment, but section 1014(b)(1) does not require inclusion in the grantor’s estate. Section 1014(b)(1) only requires that the asset be acquired by bequest, devise, or inheritance.

Section 1014(b)(1) reads as follows:

Property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent;

The relevant portion of Section 1014(b)(9) reads as follows, with the bold emphasis added:

In the case of decedents dying after December 31, 1953, property acquired from the decedent by reason of death, form of ownership, or other conditions (including property acquired through the exercise or non-exercise of a power of appointment), if by reason thereof the property is required to be included in determining the value of the decedent’s gross estate under chapter 11 of subtitle B or under the Internal Revenue Code of 1939. In such case, if the property is acquired before the death of the decedent, the basis shall be the amount determined under subsection (a) reduced by the amount allowed to the taxpayer as deductions in computing taxable income under this subtitle or prior income tax laws for exhaustion, wear and tear, obsolescence, amortization, and depletion on such property before the death of the decedent. Such basis shall be applicable to the property commencing on the death of the decedent….

Nothing in the language of the Statute, the Regulations, or the legislative history related to the passage of the Statute “affirmatively preclude[s] transfers made under a lifetime trust from qualifying as a bequest or devise.”[4] “[B]ecause a grantor trust’s assets are deemed to be owned by the grantor for income tax purposes, a good argument can be made that the assets held in such trust should be viewed as passing as a bequest or devise when the trust ceases to be a grantor trust at the moment of death.”[5]

As reported by Steve Akers for the Bessemer Trust Company, at the Estate Planning for the Family Business Owner, which was co-sponsored by the ABA Section of Real Property Trusts and Estate Law and the ABA Section of Taxation which was held from July 8th through July 10th, 2015, noted author and lecturer, Howard Zaritsky, discussed the article and whether he believed that an adjustment in basis should occur on the death of the grantor.[6] Howard stated at the conference that there was a “not bad” argument that the assets of a grantor trust should receive an adjustment in basis on the death of the grantor.

According to Mr. Akers, Howard further stated that he “would be willing to take that position on a return, advising the client that the IRS will fight the issue if it spots the issue.” Howard believed there was a minimal risk of penalties for taking that position because it is not contrary to any existing law and he felt that it is supported by some law.7

In Private Letter Ruling 201245006, a Taxpayer, who was a citizen of a foreign country, created an irrevocable trust. Pursuant to the terms of the trust, the assets were held for the taxpayer during the taxpayer’s lifetime. On the death of the taxpayer, absent the exercise of a power of appointment by the taxpayer, the assets of the trust would be held in further trust for the benefit of the taxpayer’s descendants. The taxpayer requested confirmation that the assets of the trust would receive an adjustment in basis equal to their fair market value as of the death of the taxpayer.

The IRS concluded that the basis of the trust assets would be equal to their fair market value as of the taxpayer’s death. Pursuant to the analysis of the Private Letter Ruling, Section 1014(b)(1) provides that property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent shall be considered to have been acquired from or to have passed from the decedent for purposes of Section 1014(a). The IRS acknowledged that Section 1014(b)(9), which requires assets receiving an adjustment in basis to be included in the estate of the decedent, does not apply to property described in any other paragraph of Section 1014(b).

The Private Letter Ruling indicated as follows:

Taxpayer’s issue will acquire, by bequest, devise, or inheritance, assets from Trust at Taxpayer’s death. The assets acquired from Trust are within the description of property acquired from a decedent under Section 1014(b)(1). Therefore, Trust will receive a step-up in basis in Trust assets under Section 1014(a) determined by the fair market value of the property on the date of Taxpayer’s death.[7]

The above views were also confirmed by Diane Freda in her June 18, 2015 Bloomberg BNA article entitled “IRS No-Rule on Basis in Grantor Trust Sales Reflects Clash of Opinions.” In the article, Diane Freda quotes tax practitioner and authority Diana Zeydel, as stating that there are “completely cogent, tax consistent arguments that when grantor trust status is turned off, there may be room to conclude that the trust gets a step-up in basis by reason of the Grantor’s death.”

When asked about the situation in June of 2015, and many times thereafter, Mr. Blattmachr responded that his position on the issue has not changed since the publication of his 2002 article. “You own those assets up until the moment you die for income tax purposes. We believe at that time, you, the individual, at your death, have for the first time, transferred those assets, which will not be to the trust, which did not exist for income tax purposes until the moment you die.”

Section 6694(a) provides that a tax preparer can be subject to accuracy related and understatement penalties for preparing a tax return without providing Adequate Disclosure if such Adequate Disclosure is necessary.

Specifically, Section 6694(a) provides that this liability can occur if:

(1) the preparer knew of the position; and (2) either

(a) the position is related to a tax shelter or reportable transaction;

(b) the position is not disclosed in the manner provided in Section 6662(d)(2)(B)(ii) (related to Adequate Disclosure on a tax return) and there was not substantial authority for the position(emphasis added); or

(c) the position was disclosed but there was no reasonable basis for the position.

Because the IRS now takes the position that the assets of the grantor trust do not receive an adjustment in basis on the death of the grantor, it may also conclude that there is no Substantial Authority that can be relied upon to take the position that the assets of the grantor trust do receive an adjustment in basis, regardless of whether this is correct. A return preparer would need to provide Adequate Disclosure of this position A taxpayer provides Adequate Disclosure of the tax treatment of an item if either: (a) the disclosure is made on a properly completed Form 8275 (or Form 8275-R if the treatment of an item is contrary to the treatment stated in a Regulation issued by the IRS), which is attached to the taxpayer’s return; or (b) the tax treatment is disclosed on the taxpayer’s return in accordance with the Revenue Procedure specifically providing that disclosure of the tax treatment on a tax return is sufficient. If the Revenue Procedure does not provide such authority, then the disclosure must be made on a properly filed Form 8275 or 8275-R, as applicable.

Revenue Procedure 2022-41 provides that certain positions can be adequately disclosed on an income tax return without attaching a Form 8275. Based on our review, the Form 1041 tax return which will be filed by the Trust after the death of the grantor does not qualify under this Revenue Procedure as providing Adequate Disclosure. Treas. Reg. 1.6662-4(f)(2) provides that if Revenue Procedure 2022-41 “does not include an item, disclosure is adequate with respect to that item only if made on a properly completed Form 8275 or 8275-R, as appropriate, attached to the return for the year or to a qualified amended return.”

In Rothstein v. Comissioner 735 F.2d 704 (2d Cir. 1984), the Taxpayer sold property which had a basis that was higher than its fair market value to an irrevocable disregarded grantor trust and claimed the loss on his federal income tax return.

The IRS challenged the Taxpayer’s position, by claiming that because the trust was disregarded for income tax purposes, the sale between the taxpayer and the trust should be disregarded.

The Tax Court agreed with the IRS that the sale would be disregarded for income tax purposes, but the Taxpayer appealed the Tax Court’s decision to the Second Circuit Court of Appeals, which agreed with the Taxpayer that the trust should not be disregarded for purposes of the sale.

The IRS disagreed with the result and issued Revenue Ruling 85-13 to have all such sales disregarded, apparently without thinking through that in the long run the ability of Taxpayers to sell appreciated assets to irrevocable trusts that are disregarded for income tax purposes would cause a significant tax advantage for federal estate and gift tax purposes. This occurred during the Reagan administration, when Donald Regan was the Treasury Secretary. It is unknown to the authors whether the real purpose of the IRS issuing Revenue Ruling 85-13 was to help taxpayers who would want to reduce federal estate and gift taxes by making sales to irrevocable trusts, but this is what has occurred.

Given that the IRS took the position in Revenue Ruling 85-13 that the income tax treatment of a transaction between the grantor of an irrevocable disregarded trust and the trust itself would be disregarded, it is not a far leap to conclude that the assets in that same disregarded trust would be considered as having been devised or bequeathed by the grantor at the time of the grantor’s death for purposes of IRC Section 1014(b)(1). Because of the IRS’s opposition to the Rothstein appellate courts’ conclusion and the issuance of Revenue Ruling 85-13, it seems to the author’s that there could have been and could continue to be “Substantial Authority” for the proposition that there should be a step up in basis on the death of the Grantor.

The very fact that the IRS issued a Private Letter Ruling in 201245006 which followed this position, and did not rule or provide any official indication of having an opinion one way or the other on the issue is further evidence that there was and still is Substantial Authority for this.

It would be expected that a future Tax Court or Court of Claims and appellate court decision on the issue will note that the issuance of Revenue Ruling 2023-2 followed extreme political pressure put on Secretary of the Treasury Yellen and the Biden administration in general by prominent Senators who have significant support from interest groups that strongly encourage the removal of tax advantages that exist for the wealthy.

While not providing disclosure of this position may expose a taxpayer and his or her tax advisors to an understatement penalty, we believe that it is safer for a tax return to take the position that the assets of a grantor trust receive an adjustment of basis on the death of the grantor rather than risking a malpractice claim from the grantor’s heirs in future years. If necessary, a tax advisor may want to consider entering into an Indemnification Agreement with the grantor’s family whereby they would agree to indemnify the tax advisor if he or she becomes exposed to any penalties associated with a potential understatement.

Causing the grantor’s estate to be estate taxable could save even more income tax than the estate tax that becomes payable if leveraged property is owned by the trust.

For example, if a completely depreciated apartment building worth $20,000,000 and subject to a $17,000,000 mortgage is owned by the trust and the Grantor is given a power to appoint the apartment building subject to the mortgage to creditors of the Grantor’s estate then there would be $20,000,000 of new depreciation that could be taken or the building could be sold, and $20,000,000 of deprecation recapture income would be saved, plus any state income tax savings, would apply.

The entire value of the building would be considered to be in the gross estate of the Grantor for estate tax purposes, but the mortgage thereon would be considered to be a liability of the grantor, even if it is not recourse, under the US Supreme Court case of Crane v. Commissioner (331 U.S. 1 (1947)) resulting in net estate tax inclusion of only $3,000,000 of value.

Alternate Strategies

Clients who do not want to rely on the death of the grantor causing the assets of a grantor trust to receive a new fair market value income tax basis, have other ways to receive such an adjustment.

Methods to achieve this on the death of the Grantor are as follows:

SWAP CASH OR HIGH BASIS ASSETS OWNED BY THE GRANTOR WITH THE TRUST.

The grantor can swap non-appreciated asset, less appreciated assets, or cash with the trust before death so that the appreciated assets received from the trust will receive a new fair market value income tax basis.

Pursuant to Revenue Ruling 85-13 the sale or exchange of assets between the grantor of a disregarded grantor trust and the trust itself is not subject to federal income tax. Although certain Senators have called upon the Treasury Department to reverse this Revenue Ruling, that has not yet occurred, and is not expected to occur any time soon.

THE GRANTOR CAN BORROW MONEY AND BUY LOW BASIS ASSET FROM THE TRUST.

If the grantor does not wish to swap assets with the trust or does not have low-basis assets to swap with the trust, then the grantor could borrow money from a banking institution, family member, or entity and purchase assets from the trust in exchange for cash.

After the grantor’s death, the appreciated assets could be sold, and the money borrowed could then be repaid to the lender, with interest. The cost of paying interest, which will further reduce the size of the estate of the grantor, must be considered in determining whether this strategy is worthwhile.

THE GRANTOR CAN PURCHASE ASSETS FROM THE TRUST FOR A NOTE.

The grantor could purchase the assets from the Trust in exchange for a promissory note and pay fair market value interest on the note. The interest paid by the grantor to the trust would further reduce the value of the grantor’s estate, but if the asset or assets purchased increase in value after the sale in excess of the interest rate charged on the promissory note, then this technique would add to the size of the grantor’s estate.

Upon the death of the grantor, the assets received in exchange for the note would receive a step up in income tax basis, and could then be transferred back to the Trust in satisfaction of the promissory note. There should be no gain or loss reported on the installment obligation when paid as the assets sold received a step up in income tax basis on the death of the grantor.

For example, the preferred shares might grow at a guaranteed rate of 8% per year and the common shares would be entitled to most growth exceeding 8% per year.

If the Grantor buys the preferred interest from the trust in exchange for a promissory note bearing interest at 7% a year, then there would only be a 1% per year plus limited growth arbitrage to add to the Grantor’s estate for estate tax purposes.

GIVE A NON ESTATE TAXABLE GRANTOR A GENERAL POWER OF APPOINTMENT OVER TRUST ASSETS.

The grantor could be given a power to direct trust assets to creditors of the grantor’s estate upon death. This would cause the assets of the trust to be considered as owned by the Grantor for federal estate tax purposes, but this may be worthwhile if the grantor’s net worth is less than the estate tax exemption amount. This may be installed by a court order, an agreement among the interested parties, or by Trust Protectors.

STEP UP ON THE DEATH OF A PERSON OTHER THAN THE GRANTOR.

Someone other than the grantor can have a Power of Appointment over trust assets. Under Internal Revenue Code Section 1014(b), assets subject to what is known as a general power of appointment receive a fair market value income tax basis on the death of the power holder.

The Grantor of the trust may have a family member or even close friend with a similar or shorter life expectancy than the Grantor who may be given a power to appoint assets to creditors of such individual’s estate. This would cause the assets that the power of appointment is exercisable over to be considered as owned by the power holder on death, and will cause a step up in income tax basis, even if the power holder is not a beneficiary of the trust, and even if the power is exercisable only with the consent of one or more individuals who do not have any beneficial interest in the trust or a fiduciary duty to exercise or not exercise the power.

Tax advisors, including both CPAs and attorneys, owe a duty to their clients to help minimize the potential taxes that the client faces. To fulfill this obligation, advisors should provide each client with all of the potential options available to the client, especially in any area which is uncertain under the tax law. If an advisor simply assumes that no adjustment in basis is possible for the assets of a grantor trust on the death of the grantor, then the client will be forced to take a carry-over basis for the assets, instead of having the basis of each asset adjusted to its fair market value at the time of the grantor’s death.

Practitioners should at least make their clients aware of the uncertainty regarding this issue. An informed client can decide to take the position that an adjustment in basis occurred on the death of the grantor, instead of accepting a carry-over basis. Such client would need to understand that on audit, the IRS may be expected to take the position that no adjustment should have occurred, although they could be wrong. Stay tuned for future litigation.

CONCLUSION:

The Internal Revenue Service waited more than a decade to reverse the position that was taken in Private Letter Ruling 201245006 with respect to whether the assets in an irrevocable trust that is disregarded for income tax purposes but considered to be a complete gift and outside of the estate of the Grantor for estate tax purposes will receive a step-up in income tax basis on the death of the Grantor. Revenue Ruling 2023-2 is an important event for advisors who wish to help assure that their clients have the advantage of a new fair market value income tax basis, which we believe is supported by the language of Internal Revenue Code Section 1014. It is of interest to us that some members of the tax community have generally cast aspersion on those who support the proposition that a step-up does occur. If and when the Tax Court, the Court of Claims, and/or an appellate court agree with the position that a step-up in basis has occurred on the death of a Grantor, then tax practitioners and their clients will question whether the best advice was to not take the step-up, or to take the step-up and advise the IRS in the conventional manner available of the position taken. Many taxpayers will file an income tax return and pay the tax as if no step-up occurred, and then file an amended return with prominent disclosure to reduce or eliminate the IRS’s ability to impose negligence and substantial understatement penalties. Until then, we must continue to educate our clients in the best manner possible. If the opinions of Jonathan Blattmachr, Mitchell Gans, Howard Zaritsky, and Diana Zeydel are incorrect, then maybe the world is flat![8] Galileo would probably disagree.

Special thanks to Kenneth J. Crotty, Brandon L. Ketron and peter M. Farrell on their hard work with this article.

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