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How the IRS Recently Changed the Rules on Irrevocable Trusts

The recent issuance of Revenue Ruling 2023-2 by the IRS has brought significant implications for estate planning, mainly when it involves irrevocable trusts. Over the past decade, an increasing number of families have turned to this instrument as a means of safeguarding their assets from being depleted to meet eligibility criteria for government benefits like Medicaid and VA Aid and Attendance. Many more estates have used irrevocable trusts to reduce tax liability through a step-up in basis.

A step-up in basis is important because it provides significant tax benefits to beneficiaries when they inherit assets, such as property or investments, from a deceased individual. This tax provision allows the beneficiaries to reset the cost basis of the inherited assets to their fair market value at the time of the original owner’s death. As a result, any appreciation in value that occurred before the owner’s death is effectively eliminated for tax purposes.

With a step-up in basis, the beneficiaries’ record-keeping becomes more straightforward. They only need to track the value of the asset at the time of inheritance, rather than its historical cost basis, which might have been established many years earlier. The step-up in basis can act as an incentive to hold onto assets for a more extended period. If they hold onto the assets and sell them later at a higher price, the capital gains tax burden will be even lower. This can help reduce speculation and the instability it can foster. Thus, this provision is crucial to help avoid capital gains tax, simply record keeping, and encourage long-term holding.

Before this ruling, there was ambiguity surrounding whether assets passed to beneficiaries through an irrevocable trust would enjoy a step-up in basis, effectively eradicating any capital gains taxes that might be incurred otherwise. Normally, if assets are disposed of during an individual’s lifetime, capital gains taxes apply to the appreciation in value since the time of purchase. However, when assets are inherited upon the owner’s death, they receive a step-up in basis, which means the beneficiaries assume ownership at the current fair market value, eliminating the need to pay capital gains taxes. Prior to March 2023, such transfers from the trust at death have been generally receiving a step-up in basis.

Your Rights Regarding an Irrevocable Trust and Its Details Regarding the New Ruling.

The ruling’s focus is on assets held within an irrevocable trust that is not included in the taxable estate upon the owner’s death. Historically, these transfers from the trust to beneficiaries after the owner’s passing have generally received a step-up in basis. However, the new IRS ruling stipulates that such assets will no longer receive this benefit.

Initially, it might seem like establishing an irrevocable trust would result in additional taxes for beneficiaries. But the crucial point in the IRS decision lies in how the trust is structured. Only those assets held in an irrevocable trust, which are not otherwise included in the estate for estate tax purposes, will lose the step-up in basis. This means that if an irrevocable trust is set up correctly, it is still possible for the assets to be included in the taxable estate at death, safeguarding them from capital gains and estate taxes and allowing them to pass to beneficiaries tax-free.

Fortunately, for most families, the federal estate tax only applies to estates valued at $12.92 million or more, including the value of their home. This means that the estate tax is not likely to impact them, at least until the estate tax limit is expected to decrease in 2026.

Defining Irrevocable Trusts

An irrevocable trust is a legal arrangement or fiduciary relationship in which the grantor (the person creating the trust) transfers ownership of assets or property to a trustee. Once the assets are placed into the trust, the grantor relinquishes all control and ownership rights over them, making the trust “irrevocable,” meaning it cannot be altered, amended, or revoked without the consent of all beneficiaries. The primary benefits of creating an irrevocable trust are asset protection, tax reduction, medicare and entitlement protection, and avoiding probate.

What the Change Means for Current and Future Trusts

The ruling is a clarification of the tax law and provides taxpayers with a clearer understanding of how the IRS interprets specific tax provisions. Taxpayers and tax professionals often use revenue rulings as guidance when structuring transactions or planning to ensure compliance with official interpretations. Revenue Ruling 2023-2 addresses issues related to estate planning and affects how individuals and families structure their trusts, gifts, and estates to minimize taxes and protect assets.

How to Set Up an Irrevocable Trust Correctly

Given the complexity of the changing tax laws, it is essential to seek professional advice from an attorney knowledgeable in elder law and estate planning if you have or are considering an irrevocable trust. Involving a tax professional in the process can also ensure that no critical elements are overlooked in your estate plan. With careful planning and sound advice, you and your children can navigate these complexities and come out ahead.

Our knowledgeable attorneys counsel clients on trust and estate planning issues regularly. If you find yourself ready to move forward but need more clarity, we are happy to answer your questions and provide legal advice. We will step up and get involved to help you protect your assets.

Call the trusted attorneys at Lowthorp Richards at (805) 981-8555 or fill out our online contact form. We operate primarily in the Tri-Counties area  – Ventura, Santa Barbara, and San Luis Obispo

NOTE: The information contained herein is not intended to be legal advice and the reader should know that no Attorney-Client relationship or privilege is formed by the posting or reading of this article which is also not intended to solicit business.

Cristian R. Arrieta, Lowthorp Richards McMillan Miller & Templeman, A Professional Corporation, 300 E. Esplanade Drive Suite 850, Oxnard, CA 93036