Introduction

One of the challenges in estate planning is keeping assets out of the deceased owner's taxable estate while still ensuring the assets receive the automatic change in basis (commonly called the step-up in basis) under Internal Revenue Code Section 1014. When the estate tax rates were much higher than they are today (70%-77% a few decades ago compared to 40%) and the long term capital gains income tax rates were not more than 25%, it was beneficial in most cases to seek estate tax exclusion even if the step-up in basis was forfeited. Also, unless the assets had a zero or a negative basis when the client died, there would be some basis, thereby offsetting some of the gains, even if no step-up in basis occurred under Section 1014.

[Note that this section does not apply to the right to income in respect of a decedent dealt primarily in Section 691, such as interests in an individual retirement account.]

Some Background

Mitchell Gans, Jonathan Blattmachr, and Hugh Jacobson explored the basis of property in a grantor trust when the grantor of a grantor trust died, but the assets were not included in the grantor’s gross estate in their September 2002 article, “Income Tax Effects of Termination of Grantor Trust Status by Reason of the Grantor’s Death,” published in vol. 97 of J. Tax’n (p.149).  They concluded that the assets would receive the automatic change in basis under Section 1014. 

Since the article’s publication, the IRS issued two contradictory but unofficial positions. CCA 200937028 asserts that an asset can never get the change in basis at death unless it is included in the gross estate  PLR 201245006 states that there would be a step-up in basis for assets in a grantor trust when the grantor dies, even if the assets are not included in the grantor's gross estate. Under Section 6110(k)(3), neither a CCA nor a PLR may be cited or used as precedent.

The IRS Speaks Again

Throughout the years, inquiries were made to the IRS about the multiple stances, but the IRS did not take a formal position until they issued Rev. Rul. 2023-2. This ruling concluded that the assets in a grantor trust would not receive the automatic change in basis under Section 1014 upon the grantor’s death if the assets were not included in the grantor’s gross estate. But, as noted below, the ruling does not apply in certain situations, such as where there is debt at death between the grantor and the trust, which may frequently occur when property has been sold by the grantor to the trust for a note.

In vol. 139 of J. Tax’n published September 2023, Gans and Blattmachr discussed what they believed to be flaws in the revenue ruling in “Grantor Trust Assets and Section 1014: New IRS Ruling Doesn’t Solve the Problem,” (p.16) . They pointed out that Section 1014(a) provides that assets received by someone by reason of the owner's death, or which pass to someone by reason of the owner's death, do have their basis changed (usually, stepped up). They also discussed that Section 1014(b) sets forth several categories of assets that are treated as having been acquired from or to have passed from the decedent. Most of these would be included in the decedent’s gross estate for federal estate tax purposes.  For example, Section 1014(b)(2) and (4). But some are not included, such as a surviving spouse's half of community property (Section 1014(b)(6) ).  Perhaps most importantly, they pointed out that Section 1014(b) does say that only the categories of assets listed are treated as passing from the decedent for purposes of Section 1014(a). The authors mentioned that when the tax law wants to limit something to certain areas, it uses the word "only" or some other phrasing to show the limitation of the rule. Both Section 544(a)(2) and (4) provide examples of this.  They pointed out that Section 1014(b) contains no such limitation. 

The authors also discussed that the ruling’s focus on the state law treatment of inherited property is problematic because of the long-held official position of the IRS that assets in a grantor trust are deemed owned for income tax purposes by the grantor. See Rev. Rul 85-13 and Reg. 1.1001-2(c) Example 5. And since the IRS position is that, up until death, the property in the grantor trust is owned by the decedent, they pointed out that, logically, the property must have passed from the decedent at death. The ruling also expressly posits no debt between the grantor and the trust, making the ruling inapplicable if there is  outstanding debt between them when the grantor dies. Some might contend that if there is such debt, the ruling suggests a change in basis under Section 1014 would occur upon the grantor’s death.

The authors also note, because the IRS has taken inconsistent positions, the usual deference courts give to revenue rulings should not apply. 

How to Secure the Basis Increase Without Taking on the IRS Position

Perhaps more importantly, even if one does not "buy" the theory of the step-up in basis for assets in a grantor trust when the grantor dies but not in the grantor's gross estate, the desired result can be achieved by having the grantor repurchase the assets from the trust before the grantor dies. Such a purchase has no income tax effect because, under Rev. Rul 85-13, 1985-2 CB 184, the assets in the grantor trust are always treated as owned by the grantor for income tax purposes. Hence, buying the assets back, even if just before death, means they will be included in the grantor's gross estate ensuring the tax-free step-up in basis with no gain recognized by the pre-death purchase. This strategy could be even more advantageous  than successfully establishing that the automatic change in basis under Section 1014 occurs for assets in a grantor trust because all assets, including those that have declined in value, would have their basis changed upon death. By allowing the grantor to pick and choose which assets to buy back prior to death, the grantor would presumably purchase only those that have increased in value.

One important caveat: it seems inappropriate to have the grantor buy back the assets using a note payable by the grantor. The note, which would be owned by the trust, may have a zero basis, leading to gain recognition when the note is paid after death. A better strategy would be to repurchase the assets from the grantor trust using high-basis assets, such as cash, even if the grantor has to borrow the cash just before death.

Conclusions

Almost all sophisticated estate plans involve trusts. It seems appropriate to advise clients of the possibility of achieving the impossible using grantor trusts which exclude assets from the gross estate but obtain the equivalent of a tax-free step-up in basis.

Mitchell M. Gans is the Rivkin Radler Distinguished Professor in Taxation at Hofstra University School of Law, where he serves as the Academic Editor of the ACTEC Journal.

Martin M. Shenkman, CPA, MBA, PFS, AEP (distinguished), JD, is an attorney with Shenkman Law in private practice in New York. His practice is estate planning and he is the author of 42 books and more than 1,400 articles. He has received numerous awards and is a frequent source for numerous publications and has made guest expert appearances on major financial and other television and radio shows. Active in many charitable and community causes and organizations, Mr. Shenkman has written books for the Michael J. Fox Foundation for Parkinson's Research, the National Multiple Sclerosis Society, and the COPD Foundation. He has also presented over 60 lectures nationwide on this topic for professional organizations, charities, and others.