Step-Up in Basis for Assets in a Grantor Trust: The Mystery is Solved?
A look at Rev. Rul. 2023-2
“Property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent…”
IRC Section 1014(b)(1).
This simple subsection of one of the most significant income tax provisions (IRC 1014) has been the subject of much angst, and interpretation, during the last several years. One central question, throughout this debate, has revolved around the application of this subsection.
What is this question, you ask? It is whether appreciated grantor trust assets might be subject to a step-up in basis, even if not included in the grantor’s gross estate, if the grantor trust status was terminated as a result of the grantor’s death. In other words, can you get a step-up in basis for assets transferred during the grantor’s life, without gross estate inclusion, by using a grantor trust?
I won’t rehash the arguments, as many thought leaders have come up with very artful ways to argue this point. But, the crux of the argument has been the application of the subsection cited above. Working backwards, IRC Section 1014(b)(9) provides that appreciated property included in the gross estate is generally subject to a step-up in basis, not including post-transfer depreciation deducted by an owner other than the decedent. For assets transferred to grantor trusts for which the grantor is a deemed owner, however, the intent is to avoid inclusion of the trust assets in the gross estate. This is, after all, the typical goal of such lifetime transfers – freezing the value of the transferred assets for gift, estate, and/or GST tax purposes, perhaps at a discount.
While gross estate inclusion is traditionally the ticket to entry for a step-up in basis, practitioners have often cited 1014(b)(1) for the proposition that property does not need to be included in the gross estate for basis step-up purposes so long as it is acquired from the decedent by bequest, devise, or inheritance. While property transferred to a trust during a grantor’s life is not technically acquired from the grantor (on paper) at the grantor’s death, the tax fiction of the grantor trust creates a deemed transfer at the grantor’s death for income tax purposes only – a transfer from the grantor (as deemed income tax owner of the trust assets by virtue of grantor trust status during life) to the trust (as legal titleholder, and deemed income tax owner after the grantor trust status terminates as a result of the grantor’s death).
So, a better way to reframe our question above has traditionally been: Does this deemed transfer for income tax purposes from the grantor/decedent, to the trust, at the grantor’s death constitute a bequest, devise, or inheritance?
Revenue Ruling 2023-2 has finally revealed the position of the IRS. This position should come as no surprise.
Rev. Rul. 2023-2
Cutting to the chase, this Ruling completely ignored this deemed transfer and focused solely on the actual mechanics of transfer. In other words, deemed ownership by a grantor (for income tax purposes only) immediately prior to the grantor’s death was completely ignored.
Instead, the Service focused on the legal definitions of bequest, devise, and inheritance. Ultimately, the Service concluded that a transfer from a decedent under IRC Section 1014(b)(1) can only come from property included in the decedent’s probate estate. Following this line of reasoning while citing Bacciocco v. U.S., 286 F.2d 551 (6th Cir. 1961), the Service concluded that a bequest and devise can only be made under a will, while an inheritance can only be received under laws of intestacy or heirship.
There is not much to say beyond this. Essentially, what this outcome boils down to is that assets held in trust at a grantor’s death cannot get a step-up in basis unless they meet one of the other 9 forms of qualifying transfers from a decedent under IRC 1014(b). The most applicable qualifying transfers in this vein would be property included in the gross estate (IRC 1014(b)(9)), community property (IRC 1014(b)(6)), or property for which a QTIP election was previously made (1014(b)(10)).
Conclusion
This is not a surprising analysis, and in my opinion the Service got it right. If all we had was IRC 1014(a) – focusing on “property acquired from the decedent” as the ticket to entry for a step-up in basis – the deemed transfer from a deemed owner to a trust for income tax purposes at the termination of a grantor trust power could fit the definition of property acquired from a decedent. Unfortunately, as analyzed above, we cannot stop there – this Code Section goes to great lengths to define and limit property acquired from a decedent under IRC 1014(b). And, this definition applies to actual transfers of legal title occurring as a result of a decedent’s death, or the actual lapse, release or exercise of a power over property as a result of a decedent’s death.
Of course, it should be noted that this is just a statement of the Service’s position. We have long known that Treasury has had this basis step-up issue on its radar, and this Ruling is the logical next step. However, this does not mean that the Tax Court or some other court would agree. So, if you or a client has the stomach for it, perhaps you can press the issue.
What I will say, however, is that the step-up in basis rule is really just an extension of a policy of not applying both the federal income tax and estate tax to the same asset. Since both the basis and appreciation of an asset with built-in gain are subject to estate tax, it makes sense to allow a step-up in basis. But, there is already a loophole in the form of the step-up received through the estate tax applicable exclusion amount (which includes both the basic exclusion amount, and any deceases spousal unused exclusion amount preserved by the estate of a predeceased spouse). When you consider the step-up issue from this angle, it seems a stretch to claim that post-transfer appreciation in assets transferred to a grantor trust can be wiped out without a corresponding application of the estate tax provisions (including the estate tax applicable credit).
One additional item of note is that the Ruling cited, but did not reverse, Rev. Rul. 84-139. This prior ruling analyzed a situation where a U.S. citizen inherited property in another country from a U.S. nonresident, in accordance with the heirship laws of that country. The Service held that the property received a step-up in basis, despite not being included in the nonresident’s U.S. gross estate. This outcome squares with the newer ruling’s analysis of the term “inheritance,” which requires receipt of property under intestacy or heirship laws applicable to the inherited property.