Decoding the IDGT Debate: IRS Revenue Ruling 2023-2 and Its Impact on Estate Planning
The world of estate planning is a complex labyrinth, one that requires a keen understanding of the ever-changing tax laws and regulations. One such recent development that has been the subject of much discussion among estate planning professionals is IRS Revenue Ruling 2023-2. This ruling has significant implications for the use of Intentionally Defective Grantor Trusts (IDGTs), a popular estate planning tool.
The IDGT: A Brief Overview
Before we delve into the implications of the ruling, let’s take a moment to understand what an IDGT is. An Intentionally Defective Grantor Trust is a unique estate planning tool that allows for the separation of income tax and estate tax responsibilities. The grantor, or the person who establishes the trust, is responsible for paying income taxes on the trust’s income. However, the assets within the trust are not included in the grantor’s estate for estate tax purposes. This separation allows the assets within the trust to grow without reductions for income taxes, which the grantor pays.
The IDGT is often used in scenarios where a wealthy individual holds appreciating assets, such as real estate or stock, and wants to shelter the future appreciation of those assets from estate taxes. The individual can sell the appreciating asset to an IDGT at fair market value in return for a promissory note that bears interest at the applicable federal rate. The grantor pays income tax on the trust’s income, but the appreciation that builds up in the trust’s assets is excluded from the grantor’s estate.
The Revenue Ruling 2023-2 and Its Implications
IRS Revenue Ruling 2023-2 addresses a scenario where a grantor makes a lifetime gift of certain assets to an IDGT established for the benefit of family members. In this ruling, the IRS confirms that the gifted assets, while taxable to the grantor for income tax purposes, are not eligible for a step-up in basis upon the grantor’s death. This means that the basis adjustment under section 1014 generally does not apply to the assets of an irrevocable grantor trust not included in a deceased grantor’s gross estate for federal estate tax purposes.
This ruling is significant because it puts an end to a long-standing debate in the estate planning community. The debate was sparked by a 2002 Journal of Taxation article co-authored by Jonathan Blattmachr, Mitchell Gans, and Hugh Jacobson. They proposed the possibility that assets inside of a grantor trust receive a new fair market value basis under IRC Sec. 1014 even where those assets aren’t includible in the grantor’s gross estate for federal estate tax purposes. This argument was compelling and led to a public debate among estate planning professionals, including a recent public debate between Jonathan Blattmachr and Paul Hood.
However, the IRS’s position in Revenue Ruling 2023-2 aligns with the traditional understanding of most estate planners. The ruling confirms that taking the “1014 applies” position has always been seen as an audit risk that few clients would bother trying.
An Example to Illustrate the Implications
Let’s consider an example to illustrate the implications of this ruling. Suppose a grantor establishes an IDGT and transfers highly appreciated stock into the trust. The grantor continues to pay income tax on the dividends from the stock, but the stock itself and its appreciation are not included in the grantor’s estate for estate tax purposes.
Under the traditional understanding, if the grantor dies, the stock in the IDGT does not get a step-up in basis. This means that if the beneficiaries of the trust later sell the stock, they would have to pay capital gains tax on the appreciation of the stock from the time it was first acquired by the grantor.
However, under the argument proposed by Blattmachr, Gans, and Jacobson, the stock in the IDGT would receive a step-up in basis at the grantor’s death, even though it’s not included in the grantor’s estate. This would mean that the beneficiaries could sell the stock with little to no capital gains tax liability.
The IRS’s ruling in Revenue Ruling 2023-2 confirms the traditional understanding and clarifies that the assets in an IDGT do not receive a step-up in basis at the grantor’s death.
While the IRS’s ruling may seem like a setback for some, it’s important to remember that the use of IDGTs remains a viable and effective estate planning strategy. The ruling simply confirms what most estate planners had assumed and practiced all along.