IRS Revenue Ruling 2023-2:
It’s Impact on Intentionally Defective Grantor Trusts (IDGT)
By Nicole R. Hewitt, Esq.
An IDGT is an estate planning tool that allows the grantor to transfer assets into a trust while retaining certain powers or interests. The retention of certain powers such as the right to swap out prior gifted assets to the trust for other assets of equal value (“power of substitution”), makes the trust “defective” for income tax. This “defect” makes the income of the trust reportable annually on the grantor’s individual tax return. However, for estate tax purposes the transfer of assets to the IDGT is considered a completed gift. As a result, the income earned and principal appreciation/growth is not includable in the grantor’s estate for federal estate tax purposes. In the end, the asset (most beneficial if it is appreciating) is removed from the grantor’s estate, the income gets taxed at the grantors individual effective income tax rate vs the higher trust income tax rate but the income is not part of the grantors estate which further reduces the grantor’s taxable estate in the process.
What does Revenue Ruling 2023-2 do? A Revenue Ruling (RR) is binding on the IRS and can be relied upon by all taxpayers while a Private Letter Ruling (PLR) can only be relied upon by the taxpayer who requested the PLR. RR 2023-2 provides clarity for taxpayers as to the tax basis of assets contributed to an IDGT. Prior to RR 2023-2 the only authority for this issue was interpretation of the tax code and a PLR that was contrary to this RR. RR 2023-2 makes clear that assets gifted to an IDGT are not eligible for a step-up in basis upon the death of the grantor, but the gifted asset gets carryover basis which retain the basis of the grantor. It was concluded in this RR that “For property to receive a basis adjustment under § 1014(a), the property must be acquired or passed from a decedent. For property to be acquired or passed from a decedent for purposes of § 1014(a), it must fall within one of the seven types of property listed in § 1014(b). [An asset funding an irrevocable trust] does not fall within any of the seven types of property listed in § 1014(b).” IRC § 1014(b) only permits a step up in basis if property is acquired by 1) bequest, 2) devise, 3) inheritance, 4) decedents estate, 5) revocable trust, 6) general power of appointment, or 7) spouse’s ½ share of community property.
Despite this RR, the IDGT is still a very powerful estate planning tool for wealth transfer and tax optimization for individuals that have a taxable estate. Often planning involves the substitution of a promissory note payable to the IDGT equal in value to the gifted assets that are pulled back out of the IDGT. Since the gifted assets are not eligible for a step-up in basis while owned by the IDGT, this power allows the grantor to substitute a promissory note for low-basis assets. In effect, this makes such low-basis assets again eligible for a step-up in basis since they are now owned by the taxpayer instead of the IDGT.