Navigating Section 1014 and the TCJA: A Deep Dive into the IRS Ruling on Basis Adjustments

Understanding the nuances of the Internal Revenue Code (I.R.C.) is crucial for effective estate planning and tax strategy. For example, estate planners must be familiar with the tax basis adjustment provisions in 26 U.S.C. § 1014. This article provides a detailed analysis of this section in light of a recent Internal Revenue Service (I.R.S.) revenue ruling. The article concludes by setting the revenue ruling within the context of the potential sunsetting of the Tax Cuts and Jobs Act of 2017 and clarifying its implications on the uncertain future of estate planning and tax strategy.

Overview of Sections 1014(a) and (b) of the I.R.C.

Generally, Section 1014(a) of the I.R.C. sets the tax basis of property acquired from a decedent at the fair market value (F.M.V.) at the date of the decedent’s death. An asset’s “tax basis” is the value used for calculating capital gains and other taxes upon its sale. Generally, the tax basis for assets is the purchase price. For example, if you purchase $100,000 worth of stock, its tax basis is usually $100,000.

Section 1014(a) of the I.R.C. sets different rules for determining the basis for inherited assets, however. Section 1014(a)(1) says the basis of property that a person acquires from a decedent is generally the F.M.V. of the property on the date of the decedent’s death, assuming the property was not sold, exchanged, or disposed of before that person died. In other words, the tax basis is adjusted from the purchase price to the F.M.V. on the date of death. A “basis adjustment” occurs when the value used to calculate capital gains and other taxes is altered due to specific events, and according to section 1014(a)(1), one such event that triggers a basis adjustment is the property owner’s death. Remember that stock you purchased for $100,000? Let’s suppose its value increases (i.e., appreciates) to an F.M.V. of $200,000. If you sold that asset before you died, you would generally have to pay capital gains taxes on the $100,000 it appreciated. But if you hold on to that asset until the date of your death, the rules in § 1014(a)(1) would adjust the tax basis of the asset from $100,000 to $200,000 for the person who inherits it. This means the beneficiary of the stock would not have to pay capital gains on the additional $100,000.

Section 1014(b) identifies specific types of property that qualify for a basis adjustment. The property types that adjust their basis upon the decedent’s death include property obtained through bequest, devise, inheritance, or directly from the decedent’s estate. Additionally, it covers property transferred into a trust by the decedent during their lifetime provided that the decedent retains the right to alter, amend, revoke, or terminate the trust at any time before their death.

Internal Revenue Service Rev. Rul. 2023-2

The facts at the heart of the I.R.S.’s revenue ruling, Rev. Rul. 2023-2 (April 14, 2023), involve an individual who establishes an irrevocable trust, transfers assets to it, and designates a beneficiary to receive the assets from the trust after they die. By doing this, they exclude the transferred assets from their estate for tax purposes but retain certain power over the assets nonetheless. Irrevocable trusts are important estate planning tools for tax avoidance but generally cannot be altered once created.

Eventually, the individual dies, and the assets are transferred to the beneficiary. Historically, § 1014(a)(1) would set the tax basis of assets at the F.M.V. at the date of the decedent’s death, thereby minimizing the future capital gains taxes to the beneficiary as discussed above. Rev. Rul. 2023-2 upended that historical practice, however.

In evaluating the facts before it, the I.R.S. ruled that the individual’s death does not trigger a basis adjustment for the assets. Why not? The assets in an irrevocable trust, which cannot be altered, amended, revoked, or terminated, are neither bequeathed, devised, nor passed by inheritance per § 1014(b).

According to the revenue ruling, “bequest” and “devise” refer to the act of giving property through a will, and an “inheritance,” though the broadest of the three terms, nevertheless does not extend to property passed via trust. And because the trust was irrevocable, the trustor did not retain the right to alter, amend, revoke, or terminate the trust. Consequently, the I.R.S. concluded the property was not covered by § 1014(b) and, therefore, the rules of § 1014(a)(1) that would adjust the tax basis to the F.M.V. at the date of the decedent’s death do not apply.

Relevance and Implications of the Ruling within the Context of the 2017 Tax Cuts and Jobs Act

Irrevocable trusts have been a staple in estate planning, used primarily to shield assets from estate taxes by removing them from the taxable estate, as was the case in the facts of this revenue ruling. And, as a result of this ruling on § 1014(a)(1), some families may have been influenced to keep more assets within their taxable estate, especially after the Tax Cuts and Jobs Act (TCJA) of 2017 increased the federal estate exemption to $13.61 million. This high threshold allows many estates to avoid federal estate taxes temporarily, diminishing the immediate need for irrevocable trusts solely for tax avoidance purposes.

This strategy gets significantly more complicated and costly, however, if the TCJA sunsets as scheduled at the end of 2025. Families that have opted to retain assets in their estate, relying on the higher exemption and the beneficial basis adjustment, could face significant estate taxes if no legislative action extends or modifies the TCJA, and the exemption threshold reverts back to $5.49 million per individual adjusted for inflation.

Charitable Planning Considerations

Considering the recent revenue ruling and potential reversion of the estate tax exemption to pre-2017 levels, planners should be aware that charitable gifts at death can help mitigate tax burdens on the decedent’s estate as well as for individual beneficiaries. Section §1014 excludes certain types of property from the “step-up” adjustment in basis at the decedent’s date of death. One such asset excluded by Sec. § 1014(c) is income in respect of a decedent or “IRD”, as defined under Section § 691, which is income earned by a person, but not collected before death. Common types of IRD assets include qualified retirement plans and compensation income. For example, when a taxable retirement account is left to heirs, the funds are susceptible to double taxation upon transfer – taxes on the estate and on the beneficiary at the individual’s income tax rate. As such, taxpayers who are charitably inclined should consider using IRD assets to fulfill charitable bequests, while leaving other assets, such as Sec. 1014 “step-up” qualifying assets (e.g. stocks and real estate), to individual beneficiaries. Thus, individual heirs will benefit from the step-up in the asset’s cost basis, the estate will be eligible for a Sec. 642(c) estate tax charitable deduction, and the decedent’s favorite charity will receive the entire value of the IRD, tax free, providing maximum impact toward its mission.

Conclusion and Next Steps

For estate planners and taxpayers, staying informed about the political environment and legislative changes and understanding detailed provisions like § 1014(a) is vital. As tax laws evolve, strategies may need to adjust to align with new rules, ensuring optimal tax outcomes for estates. Reevaluating estate plans considering potential changes to the TCJA will be crucial in the coming years.

About the Authors

Christine Sabio Socrates
Partner, Kohrman Jackson & Krantz, LLP

Christine "Tina" Sabio Socrates brings over 25 years of experience in estate planning and probate law, serving a diverse clientele including individuals, married couples, professionals, and business owners. Her extensive experience spans from handling modest estates to managing large and complex estates. Tina’s services encompass a broad range of needs, from drafting simple wills and powers of attorney to creating revocable trusts and sophisticated trust planning. She aims to meet specific objectives such as wealth transfer, business succession, asset protection, charitable giving, and minimizing estate tax liabilities.

Susan L. Friedman
Partner, Kohrman Jackson & Krantz, LLP

Susan L. Friedman is experienced in all aspects of estate planning, probate, trust and estate administration, special needs planning, charitable planning and guardianships with over 25 years of practice. She is valued by clients for her calm demeanor and ability to actively listen to address clients’ specific needs and develop individualized strategies.

Gunnar M. Crowell, J.D.
Senior Advisor, Charitable Estate Planning, American Heart Association

Gunnar M. Crowell has over 12 years of experience in trust and estate planning, planned and major gift fundraising, and non-cash asset acceptance. Before joining the American Heart Association, Gunnar served as Vice President of Legal Services at Renaissance Philanthropic Solutions Group, where he was responsible for facilitating and managing due diligence for planned and complex asset gifts and grantmaking to charity.

The opinions expressed in this article are solely those of the author and do not reflect the views or endorsements of the American Heart Association (AHA). The AHA does not endorse or assume responsibility for any information or opinions presented in this article.