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Life Insurance and the Double Step-Up


On March 29, 2023, the IRS published Rev. Rul. 2023-2 clarifying its position that, on the death of the grantor, appreciated assets in an irrevocable grantor trust do not receive a stepped-up cost basis. The ruling counters the position of some creative attorneys that, on the death of the grantor, appreciated assets held by an irrevocable grantor trust qualify for a stepped-up cost basis.


Although the Revenue Ruling seemingly settles the matter, it raises an intriguing proposition: Is there a way to use life insurance to, in essence, create a stepped-up cost basis within an irrevocable grantor trust and still reserve the stepped-up basis by moving appreciated assets out of the trust?


Placement of appreciated assets illuminates what is more important to a taxpayer — a stepped-up cost basis or protection from estate taxes. Can thoughtful use of life insurance make both possible?

The Backdrop


In general, for appreciated assets, gain on sale is taxed at capital gains rates and, if held by the grantor at death, will receive a stepped-up cost basis equal to the assets’ fair market value [1] [2]. With a grantor trust, the Tax Code creates a fiction that, even though trust assets are legally owned by the trust, for federal income tax purposes the grantor still owns the property for income tax purposes. As such, the grantor reports all income, expenses, and deductions from the trust-owned property on their personal tax return, and transactions between the grantor and the trust are disregarded for federal income tax purposes. One such provision that causes grantor trust status is the so called "swap power." This administrative power under IRC Sec 675 provides the grantor with the "power to reacquire the trust corpus by substituting other property of an equivalent value."


Revenue Rulings and Planning


Taxpayers may rely on revenue rulings such as Rev. Rul. 2023-2 as legal authority. A court, although likely to grant deference to the IRS position, is not bound to adhere to the holding in a revenue ruling. Nevertheless, as a planning matter, prudence dictates adhering to the ruling and avoiding a potentially messy and expensive legal battle with the IRS.


An Elemental Questions


Where appreciated assets ultimately end up speaks to an elemental estate planning question: Is it better for the grantor to (1) personally own an appreciated asset so that it will be taxed in the estate and receive a stepped-up cost basis or (2) leave it in trust where it will not be subject to estate taxes and will not receive a stepped-up cost basis.


For high-net-worth clients, the cost of owning an asset at death is the combined federal and state estate taxes. [3] On the other hand, if the asset is held in an irrevocable trust, the capital gains tax will be paid at the lower combined state and federal capital gains rates, only on the amount received in excess of cost basis, and only when the asset is sold. Therefore, retaining appreciated assets in trust appears to be the better move, especially if the assets are appreciating rapidly and/or if they are held in a dynasty trust and thus avoid repeat estate taxation.


For Example: Commercial Real Estate


Commercial real estate owned by an irrevocable grantor trust can be especially problematic because, frequently, through repeated 1031 exchanges and long-term depreciation, the cost basis may be at, or near, zero. In fact, in many cases the grantor may have a negative capital account which can, in effect, lead to a "negative cost basis." This can substantially increase the income tax exposure on sale.


The best course of action is to monitor the client’s health and, if the client is in poor health, swap the real estate out of the trust in exchange for an amount of cash equal to the property’s fair market value. On the client’s death, the real estate will receive a stepped-up cost basis, and the grantor trust will have full basis in the cash or the assets it invests in with the cash. The risk, of course, is that the grantor dies before the swap can be accomplished.


Consider Trust-Owned Life Insurance


Life insurance owned by the trust can play an important role in estate planning. First, the death benefit is received income tax-free by the trust, essentially a stepped-up cost basis. Life insurance is the only asset that can offer this benefit. [4] Second, cash values grow income tax-free so that the trust taxes paid by the grantor are greatly reduced. Third, the death benefit can be designed to offset the taxes on the built-in gain inherent in trust-owned assets (such as commercial real estate described above).


There are a number of creative strategies to fund life insurance including:

  • Paying premiums with excess cash flow from trust-owned assets,

  • Gift premiums or assets whose cash can pay premiums,

  • Split-Dollar funding, and

  • Substitute low basis trust assets with cash or income producing assets to pay the premiums.


 

[1] Code Sec. 1014

[2] Income in respect of a decedent (IRD) is the exception. IRD includes qualified plan assets, non-qualified executive benefit plans, the gain in annuities, and other items that would be taxed as ordinary income if recognized during the decedent’s lifetime.

[3] Estate assets used to pay estate taxes are also subject to estate taxes. This may further increase the cost of the personally-owned assets.

[4] Care must be taken not to violate the transfer for value rule — violation of which would cause the policy’s death benefit to be income taxable; effectively losing its stepped-up cost basis.


This material and the opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. The tax and legal references attached herein are designed to provide accurate and authoritative information with regard to the subject matter covered and are provided with the understanding that neither TRC Financial, nor M Financial are engaged in rendering tax, legal, or actuarial services. If tax, legal, or actuarial advice is required, you should consult your accountant, attorney, or actuary. Neither TRC Financial, nor M Financial should replace those advisors.

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