IRS Changes Rules on Irrevocable Trusts: What It Means for Your Estate Plan

Estate planning often feels like putting together a puzzle. Each piece needs to fit perfectly to pass on your legacy the way you intend. One of the trickiest puzzle pieces? Tax rules. These rules can change periodically, and when they do, they often require adjustments to your estate planning strategy.

In 2023, the IRS introduced a new rule that directly affects how assets in irrevocable trusts are treated for tax purposes.

Specifically, this change redefines how the "step-up in basis" is applied to these assets. If you have an irrevocable trust or are considering one, it's important to understand this shift and how it might influence your long-term plans.

What are irrevocable trusts?

An irrevocable trust is a type of trust in which the grantor (the person who creates the trust) gives up ownership of their assets. They then transfer their assets into the trust for the benefit of designated beneficiaries.

Once assets are transferred into an irrevocable trust, the grantor can't take them back or modify them. This is what sets it apart from revocable trusts, where the grantor retains control and can make changes during their lifetime.

People often choose irrevocable trusts for the added benefits. This includes protection from estate taxes and shielding assets from creditors or probate. An irrevocable trust allows the beneficiaries to inherit assets without the delay and expense of probate court. This offers a smoother transfer of wealth.

Until now, one of the biggest perks of using an irrevocable trust has been the potential tax advantage, specifically through the step-up in basis provision. However, that is where the new IRS rule comes into play.

What is step-up in basis?

The step-up in basis is a tax benefit that allows heirs to reset the value of inherited assets to their current market value at the time of the grantor's death. This significantly reduces the capital gains tax that beneficiaries would owe if they decide to sell the asset.

Here's a simplified example: Let's say you purchased a property for $100,000, but it holds a value of $250,000 at the time of inheritance. Without the step-up in basis, the beneficiary could be taxed on the $150,000 gain if they sell the property.

However, with the step-up in basis, the taxable amount is reduced because the new "base" value is $250,000, the market value at the time of inheritance. This provision has saved many heirs from substantial tax bills over the years.

How has the IRS changed step-up in basis for irrevocable trusts?

Rev. Rul. 2023-2 introduced a significant change regarding step-up in basis for assets held in irrevocable trusts. Under the new rule, an asset must be included in the grantor's taxable estate at the time of their death to qualify for a step-up basis.

Since assets in irrevocable trusts are generally not part of the grantor's estate, they may no longer benefit from this tax-saving provision. This means beneficiaries could face larger capital gains tax bills when selling inherited assets from an irrevocable trust. It's important to note that this rule change applies specifically to irrevocable trusts.

What does this mean for your estate planning strategy?

If your current estate plan involves an irrevocable trust, you may want to reconsider how the new IRS rule affects your financial goals. The changes could lead to unexpected tax liabilities for your beneficiaries, particularly if one of your key objectives is reducing capital gains taxes.

For some, this may mean including trust assets in the taxable estate to secure the step-up in basis for heirs. Others may need to explore different strategies for passing on wealth, depending on the size and structure of their estate. Either way, you should get a thorough review of your estate plan to identify any potential gaps or opportunities.

Making adjustments to your estate plan in light of the new IRS rule requires careful consideration. Trustors and trustees may need to weigh the benefits of keeping assets in an irrevocable trust versus including them in a taxable estate. Beneficiaries should also be aware that the step-up in basis is no longer guaranteed for irrevocable trust assets, which could impact their tax liabilities.

When should I consider working with an estate planning attorney?

Estate planning can be challenging under the best circumstances, and this new rule from the IRS adds another layer of complication. Rather than going it alone, consider working with an experienced Arizona estate planning attorney at The Law Firm of Brown & Jensen. We can explain how the rule affects your assets and offer solutions to minimize the impact. Plus, we can help you create a custom plan, including an irrevocable trust, that meets your unique needs.

Whether you're concerned about protecting your estate from lawsuits or qualifying for government benefits such as Medicaid, an irrevocable trust offers powerful advantages. Our law firm is committed to helping you build a solid estate plan that gives you peace of mind. Contact us today for a free consultation to discuss how we can help protect your assets.