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.

Introduction

The US Internal Revenue Service (IRS) has weighed in on the long-standing debate on what the basis of assets in an irrevocable grantor trust will be upon the grantor's death.

The question is an important one. For US federal income tax purposes, capital gains are calculated by subtracting the taxpayer's basis in the capital asset (e.g., the acquisition cost) from the value received upon the sale or exchange of the asset (e.g., the sale price). If an asset is received by way of a lifetime gift, the donee taxpayer's basis will be same as that of the donor (i.e., a "carry-over basis"). However, for an asset acquired or passing from a decedent, the recipient taxpayer's basis will be equal to the FMV of the asset on the date of the decedent's death.  There has been debate among tax practitioners as to the basis of the assets of a trust upon the grantor's death, where a grantor has made an irrevocable, completed gift to the trust but nevertheless retained sufficient powers so that the grantor is treated as the owner of the trust's assets and income during their lifetime. In such cases, the trust assets would generally not be subject to US federal estate tax upon the grantor's death (due to having made a completed gift to the trust during life). However, some practitioners and commentators have argued that the trust assets should qualify for a basis adjustment to FMV upon the grantor's death.

In 2015, the US Department of the Treasury stated its intention to issue "guidance on basis of grantor trust assets at death under [Section 1014 of the Code]." Those plans took a more definite shape when the Department, in its 2022-2023 Priority Guidance Plan, said it would provide "guidance regarding availability of [that section's] basis adjustment upon the death of the owner of a grantor trust described in [Section] 671 when the trust assets are not included in the owner's gross estate for estate tax purposes."

Now, the IRS has opined on this very question.

Background

Section 1014(a) provides that, for property to receive a basis adjustment to its FMV on the date of the decedent's death, the property must be acquired or passed from a decedent. The Treasury Regulations provide that property acquired from a decedent includes, principally, (1) property acquired by bequest, devise, or inheritance, or by the decedent's estate, under the decedent's will or the law governing the descent and distribution of the decedent's property, and (2) for decedents who die after 31 December 1953, property required to be included in the decedent's gross estate.

Section 1014(b) clarifies that property is considered to have been acquired from or to have passed from a decedent if it falls within one of seven types of property, including notably (1) property acquired by bequest, devise, or inheritance, or by the decedent's estate from the decedent, (2) property transferred in trust to pay income for life to or on the order or direction of the decedent with either the power to revoke the trust or the power to change the enjoyment of the trust reserved at all times to the decedent, and (3) property acquired from the decedent by reason of death, form of ownership, or other conditions thereby requiring the property to be included in determining the value of the decedent's gross estate for US federal estate tax purposes.

While property transferred by completed gift to an irrevocable grantor trust would not meet any of the circumstances qualifying for a basis adjustment at death, this Section does not squarely address the situation where the grantor continues to be treated as the owner of the trust's assets for US federal income tax purposes until death.

Given that the grantor of an irrevocable grantor trust is the owner of the trust property for US federal income tax purposes and the grantor ceases to be treated as such at the moment of death, the argument follows that the trust could be treated as acquiring the trust property from the grantor-decedent for income tax purposes at death and should be eligible for a basis adjustment.

Summary of Revenue Ruling 2023-2

Revenue Ruling 2023-2 ("Ruling") describes a US citizen settlor who settled an irrevocable trust and was treated as the owner of the trust 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 under Section 1014. 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 IRS reasoned that the property was not acquired by bequest, devise or inheritance, which is generally understood to be property given or received by will or under the laws of intestacy, because the property was transferred as a completed gift to the irrevocable trust prior to the decedent's death rather than by will or under the laws of intestacy upon or after death. Since the decedent did not hold a power over the trust that would result in the trust asset being included in the decedent's gross estate, 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. 

Are assets of grantor trusts still eligible for a basis adjustment?

The Ruling holds that merely being treated as the owner of the trust assets for federal income tax purposes is not sufficient for the assets to be treated as passing from a decedent upon the owner's death. To qualify for a basis adjustment, property must be considered to have passed (or been acquired) from a decedent.

So, as mentioned above, the Ruling does not preclude the argument that property passing from a non-US citizen who is not domiciled in the US can receive a basis adjustment even where such property would not be subject to US federal estate tax at death, as long as the property is otherwise considered to have been acquired from or to have passed from a decedent. It is notable that the IRS chose to reference a prior Revenue Ruling coming to this very conclusion in support of its position in the Ruling.

What is not explained in the Ruling is what section would determine the basis of assets in an irrevocable grantor trust upon the grantor's death if not Section 1014, except if the transfer is treated as a gift, in which case the trustee's basis in the assets would be a carry-over basis. A gift, for income tax purposes, implies that the recipient becomes the taxpayer and pays capital gains tax on a subsequent sale. With a grantor trust, the grantor continues to be treated as the owner of the trust assets for income tax purposes.

Takeaways

• Despite one of the reasons for its conclusion being that the trust assets in question were not subject to estate tax, the Ruling should not stand for the position that estate tax inclusion is required for the basis adjustment.
• Taxpayers with irrevocable, completed gift grantor trusts may need to reevaluate their income tax planning and consider alternative options if the basis adjustment was previously thought to apply. 
• The Ruling may not be the last guidance issued by the IRS in relation to basis adjustments for irrevocable grantor trusts.
• Non-US taxpayers seeking to benefit US taxpayers via trusts should continue to seek both estate and income tax advice, including on potential basis adjustment opportunities, even after the Ruling.