Every Christmas tree grower and forest landowner should review their estate plan to determine the impact of a recent IRS ruling involving grantor irrevocable trusts and stepped-up basis.
Many Christmas tree growers and forest landowners use trusts as part of their estate plan.
What is a Trust?
A trust is a legal arrangement where one party (the “grantor”) gives another party (the “trustee”) the right to hold title to property for the benefit of a third party (the “beneficiary”).
A trust is a way for the grantor to transfer assets to the beneficiary, under certain terms and conditions which the trustee follows.
Revocable Trusts
Many individuals use revocable trusts (often called “living trusts”) as part of their estate plan.
Revocable trusts are used to avoid probate, which is the legal process of proving a will in court. Revocable trusts also provide privacy of estate planning decisions, as the terms of a will are public in some states.
Revocable means that the grantor may change or even terminate the trust at any time.
Irrevocable Trusts
Another type of trust are irrevocable trusts. Irrevocable is the opposite of revocable and means the grantor may not change the trust after it’s created.
Irrevocable trusts are often used to avoid or minimize federal or state estate taxes, as property in an irrevocable trust is no longer in the taxable estate of the grantor.
Grantor Trust
A grantor trust is a trust where the individual who created the trust (the “grantor”) is considered the owner of the trust assets for tax purposes.
During the grantor’s lifetime, all income and gain from the grantor trust’s property is taxed on the grantor’s individual income tax return.
A grantor trust may be either revocable or irrevocable. For example, an individual can create a grantor revocable trust or a grantor irrevocable trust.
What is Stepped-Up Basis?
Basis is the measure of an individual’s investment in an asset. Basis can also be thought of as the amount of money that has already been taxed in an asset.
A taxpayer’s basis in an asset is the starting point to determine if the taxpayer has a gain or loss when they sell or otherwise dispose of the asset.
Cost Basis
For example, Tim Burr purchased an acre of forestland for $10,000. Tim’s total basis in the forestland is $10,000 because Tim invested $10,000 to purchase the forestland. Also, Tim purchased the forestland using money generated from other sources that has either already been taxed or was exempt from tax. Assuming no other changes, basis ensures Tim will not be taxed on the $10,000 again when he sells or otherwise disposes of the forestland.
Like the example, many taxpayers determine their basis based on what they purchased the asset for. This is known as “cost basis.” However, a purchase isn’t the only way for a taxpayer to acquire an asset.
Stepped-Up Basis
A Christmas tree grower or forest landowner may also inherit their land or business.
In this article, I’m using “inheritance” to refer to any way a forest landowner acquires forestland from a deceased individual’s estate, whether through a will or intestate succession (no will).
Generally, inherited property receives a “stepped-up” basis. This means the heir’s adjusted basis is “stepped-up” to the fair market value of the property on the date of the decedent’s death.
Because of this, inheriting assets is one of the best ways to avoid income taxes.
For example, Tim Burr’s father left him an acre of forestland in his will. Tim’s father paid $10,000 for the acre of forestland and the acre of forestland was worth $20,000 on the date of Tim’s father’s death. Tim’s basis in the forestland is $20,000 because his basis is stepped-up to $20,000 from his father’s basis of $10,000. This $10,000 step-up or “gain” is not taxed. Tim will determine his taxable gain or loss when he disposes of the forestland based on his $20,000 stepped-up basis.
Trusts and Stepped-Up Basis
Property in revocable trusts generally receives a stepped-up basis upon the death of the grantor because the property is included in the grantor’s taxable estate.
Property in irrevocable trusts generally does not receive a stepped-up basis upon the death of the grantor because the property is excluded from the grantor’s taxable estate.
Grantor Irrevocable Trusts and Stepped-Up Basis
An area of confusion often arises with respect to grantor irrevocable trusts.
Grantor irrevocable trusts are irrevocable trusts in which the income from trust assets is taxable during the grantor’s lifetime on the grantor’s individual income tax return but the trust assets are no longer in the taxable estate of the grantor.
Some tax practitioners maintained that property in grantor irrevocable trusts should receive a stepped-up basis at the grantor’s death because the grantor paid income tax on the trust assets during his or her lifetime.
However, the IRS recently ruled that property in grantor irrevocable trusts does not receive a stepped-up basis because the trust property is not included in the grantor’s taxable estate.
This ruling will affect Christmas tree growers and forest landowners who were planning on using a grantor irrevocable trust to both avoid estate taxes and give their heirs a stepped-up basis in the trust property.
Review Your Estate Planning Documents
While revocable trusts are most frequently used for estate planning, Christmas tree growers and forest landowners with a net worth over the federal exemption amount or who live in states with a state estate tax should review their estate planning documents to determine the impact of this ruling and if any changes should be made to their estate plan.
Have further questions about the recent IRS ruling or the tax implication of estate planning? Contact Andrew!
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