RECENT IRS Rule Change May Affect How You Leave Assets to Heirs

[army judge]

Jurisdiction

US Federal Law

Author:Brian J. O'Connor


A couple signs a series of documents setting up an irrevocable trust.


Managing your taxes can be one of the most complex aspects of estate planning and a new IRS rule change continues that trend. The rule, published at the end of March, changes how the step-up in basis applies to assets held in an irrevocable trust. If you need help interpreting the IRS rule change or setting up your estate, consider speaking with a financial advisor.

What Is a Step-Up in Basis?
When someone inherits an asset with unrealized capital gains, the basis of the asset resets or "steps up," to the current fair market value, wiping out any tax liability for the previously unrealized capital gains.

For example, if you purchased stock for $100,000 more than a year ago and sold it now for $250,000, you would pay capital gains tax on the $150,000 profit above the original basis of $100,000. If you inherit that stock, however, your new basis steps up to $250,000 and you'll pay tax only if you sell the stock for more than that amount.

To protect their assets, many people place them in an irrevocable trust, which means they lose all ownership rights to the assets. Instead, the trust becomes the owner of the assets for the benefit of the trust's beneficiaries.

How IRS Rule Change Impacts Irrevocable Trusts
Previously, the IRS granted the step-up in basis for assets in an irrevocable trust but the new ruling – Rev. Rul. 2023-2 – changes that. Unless the assets are included in the taxable estate of the original owner (or "grantor"), the basis doesn't reset. To get the step-up in basis, the assets in the irrevocable trust now must be included in the taxable estate at the time of the grantor's death.

That's the bad news.

The good news is that because of the $12.92 million per-person exclusion in 2023 ($25.84 million for married couples), few estates in the United States pay even a portion of the estate tax.

In 2021, 6,158 estates were required to file estate tax returns, with just 2,584 of them (42%) paying any tax at all. By including the irrevocable trust assets in the taxable estate, heirs who are the beneficiaries of the trust will dodge the tax hit and receive the step-up in basis. However, that situation could change for some people in 2026 when the estate tax exemption limit reverts to the 2017 amount of $5 million, adjusted for inflation.

Why would someone be using an irrevocable trust? A typical reason is to remove assets from your ownership in order to qualify for Medicaid nursing home assistance. A parent could place a home worth $500,000 into the trust, qualify for Medicaid but, by including the home in their taxable estate, then pass the property on to their children tax-free at a basis of $500,000.

Bottom Line
Woman discusses her estate plan with her daughter, son-in-law and grandchildren.
Woman discusses her estate plan with her daughter, son-in-law and grandchildren.
Anyone using an irrevocable trust should be reviewing their estate plan to make sure it complies with the updated IRS rule and preserve the step-up in basis for assets that the trust will pass on to their heirs. Building a sufficient estate plan is also something that most people should try to have in place in order to limit issues for their family down the road.

Financial Planning Tips
A financial advisor can help you make sense of important rule changes so your financial plan stays on track. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.

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IRS Rule Change May Affect How You Leave Assets to Heirs

 

[Tax Counsel]

The piece, which is an advatorial, is generally correct about what Rev. Rul. 2023-2 says, but makes it seem like a much bigger deal than it is. I'll first note that the ruling is not the result of a recent significant change in the view of IRS counsel. When I was an attorney at IRS counsel that was our understanding of the law.

The article also makes it sound like it is a change that affects all irrevocable trusts. In fairness to the author of the piece, the ruling is written in a way that one not knowledgeable about the fine details of the estate tax could conclude that to be the case. It is actually not nearly so broad. (Or perhaps the writer knew the ruling would affect very few estates and intended to imply it is broader than it is to bring in more potential clients to the firm that promoted the piece.)

In order for the plan to work as a promoter of this set up intended the grantor of the trust must reserve to himself or herself one of a very limited set of powers that would cause the irrevocable trust to fail to be regarded as as a trust for income tax purposes. Only a small number of irrevocable trusts would be drafted reserving those powers, especially now.

Because of the huge federal estate tax credit that exists today only a small percentage of individuals would need to use an irrevocable trust to keep assets out of the gross estate for the estate tax. A decedent would need a taxable estate of over $13 million to be concerned about that, and if the decedent is married, they can effectively shield over $26 million of assets from the estate tax. Only about 1% of the population has that much wealth. However, if some Democrats succeed in their plans for changing the estate tax then this kind of planning will once again be important for a lot more people.

State death taxes affect many more decedents today than the federal estate tax, if they happen to live in a state that still has an inheritance or estate tax. Not a lot of states have an estate tax. More of them have an inheritance tax, but those taxes tend to be small compared to the federal estate tax. And the easiest estate tax plan for people who would get hit hard by state death taxes is simply to move to one of the states that do not impose either an estate or inheritance tax.

The death tax changes from what the tax law was pre 2000 are great for taxpayers. Far, far fewer people need to be concerned about any kind of death tax today than a quarter century ago. For tax lawyers and estate planning lawyers, it's not as great as those changes have mostly killed a part of tax and estate law practice that brought in a nice chunk of income. But don't worry, I'm not starving as a result of those changes. There are still plenty of other tax and estate issues out there that I keep pretty busy.

 

[army judge]

State death taxes affect many more decedents today than the federal estate tax, if they happen to live in a state that still has an inheritance or estate tax.

Yes, 17 states still tax estates after a person passes on to her eternal rest.

17 States Still Pursue Estate and/or Inheritance Taxes

Even if you escape the federal estate tax, these states (plus D.C.) may hit you harder.

Most people don't have to worry about the federal estate tax, which excludes up to $12.92 million for individuals and $25.84 million for married couples in 2023 (up from $12.06 million and $24.12 million, respectively, for the 2022 tax year). But 17 states and the District of Columbia may tax your estate, an inheritance or both, according to the Tax Foundation.

Eleven states have an estate tax:

Connecticut, Hawaii, Illinois, Maine, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont and Washington.

The District of Columbia does, as well. Estate taxes are levied on the value of a decedent's assets after debts have been paid. Maine, for example, levies no tax on the first $6.41 million of an estate and taxes amounts above that at a rate of 8 percent to a maximum of 12 percent.

Iowa, Kentucky, Nebraska, New Jersey and Pennsylvania have an inheritance tax — that is, a tax on what you receive as the beneficiary of an estate. Kentucky, for example, taxes inheritances at up to 16 percent. Spouses and certain other heirs are typically excluded by states from paying inheritance taxes.

Maryland is the lone state that levies both an inheritance tax and an estate tax.

Federal estate tax largely tamed
The Tax Cuts and Jobs Act, signed into law in 2017, doubled the exemption for the federal estate tax and indexed that exemption to inflation. The maximum federal estate tax rate is 40 percent on the value of an estate above that amount. The higher exemption will expire on Dec. 31, 2025.

Relatively few people pay federal estate taxes. About 6,158 estate-tax returns were filed for people who died in 2021; of those, only 2,584 estates were taxable. Because of the large exemption, few farms or family businesses pay the tax.

There is no federal tax on inheritances. Heirs can get an extra advantage when they inherit an appreciated asset, such as a stock or mutual fund. When they sell that asset, the taxable gain is generally computed favorably, based on the value of the asset at the time of the original owner's death rather than the value when the original owner purchased it. That typically results in a smaller taxable gain for the heir.

17+ States With Estate Taxes or Inheritance Taxes

Inheritance Tax: Here's Who Pays And In Which States | Bankrate

2023 Estate and Inheritance Taxes by State | The Motley Fool

 

[Foamback]

The state level exemption level is much lower, sometimes shockingly so, than the feds. Washington is $2.192M, so given today's realty values, a lot of families are hit when their surviving parent passes.

My understanding is that Oregon is $1M, so it seems that would affect even surviving spouses.

In 1992 the Federal level was $600K, ouch.

 

[Tax Counsel]

In 1992 the Federal level was $600K, ouch.

Bear in mind, though that $600K in 1992 would have the same buying power today after inflation of $1.3 million dollars. Not a lot of the public in 1992 died with over $600k after deducting the marriage deduction (if married at the time of death) gifts to charitable institutions, etc. With good tax planning the tax bite on an estate over $600K was quite a bit lower than if no planning had been done.