What Does the IRS Say About an Irrevocable Grantor Trust?

Lifetime gifts to irrevocable grantor trusts have long been a staple in the estate planning playbook for those with large estates, says Advisor Hub’s recent article entitled, “IRS: Gifts to Irrevocable Grantor Trust Will Not Receive Basis Step-Up At Death.”

Gifting assets to an irrevocable trust during their lifetime allows taxpayers to remove those assets from their taxable estate at their death. Some of the taxpayer’s lifetime estate and gift tax exemption would typically be used by making the gift. Nevertheless, any appreciation in the assets after the gift date wouldn’t be subject to estate tax upon the grantor’s death.

Structuring an irrevocable trust as a “grantor trust” lets the grantor continue to be responsible for the income taxes generated by the trust during their lifetime. In other words, this permits the grantor to continue to make “tax-free” gifts by paying the tax liabilities of the trust without using further gift tax exemption. The IRS also recently addressed one outstanding question relating to completed gifts to irrevocable grantor trusts: whether the trust assets receive a basis step-up at the grantor's passing.

Internal Revenue Code § 1014 generally provides that a decedent’s assets will get a step-up in basis at death, meaning that the basis in the property will be equal to the fair market value at death (eliminating capital gains on appreciation during the decedent’s lifetime).  The IRS has stated that completed gifts to an irrevocable grantor trust won’t get a step-up in basis at the grantor’s death under IRC § 1014. Because the assets aren’t included in the grantor’s taxable estate, the IRS holds that this asset would not receive a step-up in basis at death.

This news confirms what experts had already thought about the case: assets gifted to an irrevocable grantor trust excluded from the grantor’s estate will not receive a basis step up at the grantor’s passing.

Life insurance proceeds, however, are generally income tax-free under IRC § 7702. As a result, life insurance proceeds that pay to an irrevocable grantor trust will not be impacted by this and won’t be income taxable.

Those with assets in grantor trusts should think about the income tax treatment of the trust assets during their lifetime. For example, many trusts include “swapping powers,” where the grantor can swap low-basis trust assets for higher-basis personal assets of equal value during their lifetime. This means the lower basis assets get a basis step-up by being included in the grantor’s estate, and the assets with little to no gain remain in the trust.

Reference: Advisor Hub (May 1, 2023) “IRS: Gifts to Irrevocable Grantor Trust Will Not Receive Basis Step-Up At Death”

Contact attorney John A. Laine to learn more about the taxation of trust and how to protect your family.