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Navigating the IRS Rule on Irrevocable Trusts: What You Need to Know

The IRS created a pretty major rule change about how assets are treated in Irrevocable Trusts for tax purposes. Learn more about this rule and how it may impact you.

Patrick Hicks

Patrick Hicks, @PatrickHicks

Head of Legal, Trust & Will

Estate planning can be described as a puzzle of sorts, with different pieces that need to fit together seamlessly to ensure that your legacy will be passed on according to your wishes.

One of the key puzzle pieces can be a moving target at times: tax rules that periodically change and impact your estate planning strategy.

Last year, the Internal Revenue Service (IRS) published a change that will impact the way assets held in Irrevocable Trusts are treated for tax purposes. Keep reading to learn more about how the new rule redefines the way step-up in basis will be applied to assets in these Trusts.

Analyzing this new IRS rule requires a basic understanding of how Irrevocable Trusts work in estate planning, as well as how step-up in basis is used to calculate property values for the purpose of taxes. Let's start with these definitions first.

What is an Irrevocable Trust?

An Irrevocable Trust is a type of Trust that holds assets and property for the benefit of designated Beneficiaries. The Grantor (the person who established the Trust) surrenders ownership and thus creates a separate legal entity. Once assets are transferred into an Irrevocable Trust, they cannot be taken back or removed. This type of Trust is unique from other types of Trusts with respect to this aspect. For example, a Revocable Trust can be changed or revoked during the Grantor's lifetime.

Grantors who choose the Irrevocable Trust over a Revocable one will often do so for the additional protections it offers. Any income generated by Trust assets, as well as any distributions made to the Beneficiaries from the Trust, will not be subject to estate taxes upon the death of the Grantor. This could significantly reduce the value of the estate.

The Trust’s Beneficiaries then stand to inherit the assets without the delay or expense of probate, and assets are protected from probate, divorces, and creditors (in most cases).

The step-up in basis has historically been an appealing aspect for Trust usage, but with the new IRS rule in place, the implications require a closer examination.

What is Step-Up In Basis?

The step-up in basis provision is a substantial advantage for anyone inheriting assets or property. It helps to lower the potential tax liability on unrealized capital gains attached to any inherited assets.

Here’s an example of how it works:

Imagine you inherit an asset that was originally purchased at $100,000. Today,  it is valued at $250,000. Without the step-up in basis provision, you could be taxed on capital gains in excess of the original $100,000 if you sell the property. However, with step-up in basis, the base value is bumped up to today's value of $250,000 for tax purposes. This means that if you sell the asset, you'd only be taxed on any profit made in excess of $250,000 (instead of $100,000.) This is a mechanism that has saved a significant amount in potential tax liabilities for heirs.

What the IRS Rule Change Means

Rev. Rul. 2023-2 has made a major change in the way assets are treated within Irrevocable Trusts, namely concerning the provision for step-up in basis.

The rule states that unless the asset in question is included in the taxable estate of the Grantor upon their death, then that asset will not receive the step-up in basis. As explained earlier, any assets transferred to an Irrevocable Trust are no longer part of the Grantor's estate. Beneficiaries of Irrevocable Trusts could be deprived of this highly sought-after step-up in basis and may no longer be protected from capital gains taxes.

Note that this ruling only applies to Irrevocable Trusts. The step-up in basis provision for assets or property held in Revocable (Living) Trusts are not impacted.

This change raises numerous questions, and most importantly, requires an evaluation of existing estate plan. This is particularly trust for anyone with an Irrevocable Trust currently place. Is avoiding capital gains tax a large component of your estate planning strategy? If so, then you're encouraged to review your plan promptly, as well as receive professional guidance and make amendments as needed.

Impact on Estate Planning Strategies

For anyone who has an Irrevocable Trust integrated into their estate planning strategy, then the implication of this IRS ruling could be huge.

A comprehensive estate plan review is imperative to understand the potential tax burden on Trust assets. If an objective is to maximize the benefits that come from step-up in basis provisions, then a change may be necessary.

For Trustors and Trustees, this may look like including Trust assets into their taxable estate in order to secure the step-up in basis advantage for their heirs. For Trust Beneficiaries, this means that you can no longer assume that the tax-saving vehicle will automatically apply to you. If you stand to inherit assets or property from an estate, it is always a great idea to look ahead and start developing financial and tax strategies of your own. This often begins with understanding your possible tax liabilities.

Adapting to Change

Navigating the twists and turns of estate planning, especially when it comes to Irrevocable Trusts, just got a bit trickier.

This isn't merely a matter of minor paperwork adjustments; we're embarking on an entirely new strategic approach focused on intelligent tax strategies and the seamless transfer of wealth. It is advisable to seek the counsel of experienced financial advisors or estate planning experts to navigate this complex new terrain effectively.

Seeking professional advice is crucial. They can guide you through the complexities of the latest IRS rules, applying them to your finances and assets, and identify smart, tax-efficient adjustments. This could involve revising your Trust, reevaluating estate taxes, or exploring new methods for wealth transfer. Acting now could yield significant benefits.

The significance of these IRS changes cannot be overlooked; they demand a more strategic approach. Financial advisors and estate planning attorneys are invaluable resources. While you can do a lot of research on your own, a professional can help you navigate the ever-changing landscape of these tax rules for your benefit.

Compliance isn't the only goal; you'll want to create estate planning strategies that stay aligned with your personal objectives.

Remember, estate planning is dynamic. Your plan should be poised to evolve alongside changing tax rules, life changes, and your personal aspirations.

Make Estate Planning Easier with Trust & Will

When done correctly, estate planning is treated like a living document. Yes, it does take some work to keep your plan up-to-date and make sure it stays aligned with your goals and objectives. However, doing so is a testament to your love and care for not only your family members but also for your legacy.

The rule change published by the IRS is a prime example of how remaining adaptable and flexible is the best approach to estate planning. In today's world of complicated legal changes, making informed decisions is key to protecting your money. Be flexible, stay informed, and take action in order to not only execute but also maintain an ironclad estate plan.

Do all these changes sound like a headache? Trust & Will is here to help you!  Our easy-to-use online platform makes creating and updating your estate plan a breeze. With our step-by-step guidance and expert customer support team, you can rest assured that your loved ones will be taken care of according to your wishes. Any time there’s a major change to IRS rules, it’s a great reminder to review and fine-tune your estate plan to secure a solid financial future for both you and your loved ones.

Don't wait until it's too late - start planning for the future now with Trust & Will, whether you’d like to start with a Will or dive into a Trust-based estate plan. Take our free quiz to see where you should get started, or compare our different estate planning and settlement  options today!

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