Navigating the Tradeoffs: Control, Capital Gains Tax Planning, and Irrevocable Trusts

In estate planning, asset protection, and tax planning, trusts and LLCs are powerful tools that can be used together to maximize their benefits. However, the effectiveness of these tools depends on how they are configured to work together and whether certain types of control over assets and property are surrendered by the property owner.

Some trust makers and taxpayers have been mistaken about the tradeoffs between control over assets and the potential tax planning benefits of irrevocable trusts. They had hoped that by paying income taxes on the income of a completed-gift trust under the grantor trust powers, the trust would be eligible for both a step-up in basis and for estate tax exclusion. However, this double-dip benefit is not true.

Irrevocable trusts can be treated as grantor trusts, meaning that an individual, typically the trust maker, will be treated as the owner of the trust income or principal. This individual will include all items of trust income, deductions, and credits on their personal taxes, even if the income stays in the trust and is not distributed personally. This can result in tax savings for the individual, as individual tax rates are usually lower than trust tax rates.

In early 2023, the IRS issued Revenue Ruling 2023-02, clarifying that assets in an irrevocable trust that are excluded from the trust maker’s gross estate will not receive a step-up in basis for capital gains tax, even if the trust maker continues to pay income taxes on the trust income under grantor trust income tax rules. This ruling dispelled confusion about the different sets of tax rules and reiterated that property transferred to an irrevocable trust through a completed gift does not qualify for a step-up in basis for capital gains tax savings.

Some attorneys and trust makers were shocked by this ruling, as they had hoped to save on capital gains taxes by paying trust income taxes at lower individual rates, excluding property from the gross estate, and still receiving a step-up in basis. However, it is essential to understand that making a completed gift out of the taxable estate will result in denial of a step-up in basis for trust assets, even if the trust is grantor status.

In conclusion, it is crucial for trust makers to understand the limitations of tax planning strategies involving irrevocable trusts and grantor trust status. While these tools can offer tax savings benefits, they do not allow for a double-dip benefit of both estate tax exclusion and a step-up in basis for capital gains tax. It is important to consult with a knowledgeable estate planning attorney to ensure that these tools are used effectively in estate planning.