IRS signals it will challenge IDGT basis step-up at death

Editor: Howard Wagner, CPA

The IRS recently published Rev. Rul. 2023-2, which publicly announced that the Service will be challenging a basis step-up for assets in intentionally defective grantor trusts (IDGTs). The ruling concludes that if the assets of an IDGT are not included in the grantor’s gross estate upon his or her death, those assets do not get a basis step-up.

Nature and purpose of IDGTs

An IDGT is typically used to transfer income-producing and highly appreciating assets out of an estate. The unique characteristic of IDGTs is that they are treated differently for estate and gift tax purposes than they are for income tax purposes.

Establishing an IDGT requires the grantor to settle an irrevocable trust in which the grantor retains a certain power or powers that intentionally cause the trust to be treated as a grantor trust. Status as a grantor trust essentially makes the trust invisible for income tax purposes, and the trust’s income is taxed to the grantor.

For estate and gift tax purposes, the trust is very much visible. The transfer of assets to the trust is treated as a gift, potentially triggering gift tax. Moreover, the assets are treated as belonging to the trust, not the grantor, thus escaping estate tax at the grantor’s death.

While most practitioners have concluded, as the IRS has, that there is no step-up in basis for assets in an IDGT due to the property’s not being included in the grantor’s estate, some practitioners advanced the idea that a basis step-up should be allowed. Their argument is based on the premise that the grantor owns the property for income tax purposes, and since the grantor’s death ends such ownership, it is the death that triggers the asset transfer as if by bequest or devise, and, thus, a basis step-up should be allowed.

Rev. Rul. 2023-2 clarifies IDGT treatment

Under Sec. 1014, the basis of property in the hands of a person acquiring it from a decedent is the fair market value of the property as of the date of the decedent’s death.

In Rev. Rul. 2023-2, the IRS confirmed that the basis step-up under Sec. 1014 does not apply to assets gifted to an irrevocable grantor trust. If trust assets are not included in the grantor’s gross estate for federal estate tax purposes, a basis step-up is not appropriate. In such cases, the assets of the grantor trust are not considered as acquired or passed from a decedent by bequest, devise, inheritance, or otherwise within the meaning of Sec. 1014(b), and therefore Sec. 1014(a) does not apply. For property to receive a basis adjustment under Sec. 1014(a), the property must be acquired or passed from a decedent.

This issue is not new, and, in fact, there have been previous proposals to address it. In November last year, the IRS announced in its Priority Guidance Plan that the present ruling was coming early this year. They have now held to that promise.

Looking ahead

It is advisable for clients to contact their tax adviser to evaluate what the revenue ruling means if they settled an IDGT and took a step-up in basis, and determine what options are available should the ruling negatively affect the IDGT planning. One thing tax preparers will need to consider is whether continuing to take a position that a stepped-up basis is available rises to the level of substantial authority so that a return can be filed without Form 8275, Disclosure Statement. Consider the following examples:

Example 1: At the death of the grantor of an IDGT in 2021, the beneficiaries claimed a step-up in the basis of C corporation stock. Half of the stock was sold in 2021, reflecting reduced gain due to the stepped-up basis. The remaining stock is sold in 2023. Even if the taxpayer does not reflect a stepped-up basis for the stock sold in 2023, they would need to consider any potential exposures for the 2021 tax year as a result of Rev. Rul. 2023-2.

Example 2: At the death of the grantor of an IDGT in 2019, the beneficiaries claimed a step-up in the basis of a partnership interest. A Sec. 754 election was made, and the step-up is reflected as a 15-year Sec. 197 deduction under Sec. 743. If the partnership continues to reflect the Sec. 743 adjustment with the step-up, it would need to consider if the position still is at a substantial authority level for the return to be filed without Form 8275 disclosures.

Example 3: At the death of the grantor of an IDGT in 2019, the beneficiaries claimed a stepped-up basis in a parcel of real estate. In 2021, the real estate was sold in an installment sale under Sec. 453. The sale provided for 10 annual payments of $1 million beginning in 2021 through 2030. How should the sellers compute the gross profit percentage on the remaining installment payments if they want to follow the guidance of the revenue ruling?

Ultimately, this issue may be resolved by the courts, and there is no guarantee that the IRS will prevail. Again, clients should contact their tax adviser to evaluate what the revenue ruling means if they settled an IDGT claiming a stepped-up basis, and determine what options are available if the IDGT planning is negatively affected.

Editor Notes

Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky. For additional information about these items, contact Wagner at howard.wagner@crowe.com. Unless otherwise noted, contributors are members of or associated with Crowe LLP.