A recent IRS revenue ruling discussed the interaction of irrevocable trusts established as grantor trusts and their eligibility for a step up in basis upon the death of the grantor. It is an illustration of how important it us when creating an irrevocable trust to properly consider their tax treatment.
An irrevocable trust is one that the creator cannot easily revoke or change, with some exceptions. Typically these trusts are created either for Medicaid asset protection purposes or for estate tax planning purposes. Frequently, irrevocable trusts are prepared to qualify for grantor trust status, meaning that the creator of the trust, called the grantor, is treated as the owner for income tax purposes during their lifetime. This is important to ensure any income the trust earns is still taxed to the grantor (and not to the trust, at possibly higher tax rates), and, for a Medicaid asset protection trust that owns the grantor’s home, the grantor still keeps property tax deductions and the capital gains tax exclusion on the sale of a personal residence.
Upon death, the tax treatment of a Medicaid asset protection trust and many types of estate tax planning trusts diverge, especially with regard to capital gains. Generally speaking, capital gains taxes are assessed when you sell an asset for a profit (gain). For instance, if you purchased stock for $5 and sold it for $15, you would have a capital gain of $10, and taxes may be owed on the gain. If, however, you inherited that stock before you sold it, you may have received a step up in basis. In the same example, if you inherited the stock when it was worth $15, and sold it for $15, you would not have to pay any capital gains taxes. The basis was “stepped up” to the date of death value when inherited.
In order for an inherited asset to receive a step up in basis, it typically needs to be treated as part of the deceased person’s taxable estate for estate tax purposes. Keep in mind, however, that even if the asset is included in someone’s taxable estate, there is no estate tax unless the estate exceeds the exemptions (for 2023, the federal exemption is $12.92 million and the New York exemption is $6.58 million). Medicaid asset protection trusts are typically created to intentionally include the trust assets in the grantor’s taxable estate, so their heirs receive the benefit of the step up in basis. However, estate tax planning trusts typically avoid inclusion in the grantor’s taxable estate, and would not ordinarily receive a step up in basis.
The recent IRS revenue ruling clarifies that an irrevocable trust that has grantor trust status but is not includible in the grantor’s taxable estate does not receive a step up in basis at the grantor’s death. This impacts some estate tax planning trusts (which try not to be included in the grantor’s taxable estate), but should not impact properly prepared Medicaid asset protection trusts (which try to be included).
Whether you are planning to avoid estate taxes or to protect your assets from the cost of long term care, an irrevocable trust is an essential part of many estate plans. When planning to include an irrevocable trust in your plan, it is important to consult with attorneys experienced in all aspects of trusts, including their tax treatment. Contact Kurre Schneps LLP today to schedule your consultation.
The information contained herein is general in nature and is not intended, and should not be construed as, tax advice or opinion.
