Irrevocable Trust Beneficiary’s Death: Implications on Stepped-Up Cost Basis

When an irrevocable trust beneficiary dies before receiving a distribution, the beneficiary's child often becomes the new beneficiary. This raises a pivotal question: will the child receive a stepped-up cost basis at the time of the original beneficiary's death? This article aims to clarify the conditions under which a stepped-up cost basis occurs, focusing on the relationship between the trust, estate tax, and beneficiary inheritance.

Estate Planning and the Stepped-Up Cost Basis

The threshold question is whether the assets contained in the irrevocable trust are included in the decedent's estate for estate tax purposes. The stepped-up cost basis is a tax benefit that occurs when property ownership is transferred to a spouse, heir, or beneficiary. Essentially, it adjusts the cost basis of the property to its fair market value on the date of death of the deceased owner, reducing the capital gains tax liability for the successor.

Estates and Estate Tax Inclusion

Airrevocable trust can hardly be a source of estate tax inclusion, as the trust is intended to be irrevocable and generally should not be reformed. However, there are specific circumstances that might impact this:

Powers of Distribution: If the trust enables the settlor or remainder beneficiaries to have the power to make distributions, this might lead to estate tax inclusion. Spending and Income: If the trust has the power to spend trust assets for the benefit of the settlor, this could also contribute to estate tax inclusion. Marital Deduction: If the trust avoids the marital deduction (usually by allocating the elective share to the surviving spouse), it might still be subject to estate tax. Additional Powers: Other powers, such as the power to revoke or alter the trust, can also lead to estate tax inclusion.

Scenarios and Implications

Let us explore a few scenarios to better understand when a stepped-up cost basis might occur in such cases:

Scenario 1: When Estate Tax Inclusion Occurs

In this scenario, the trust assets are taxed as part of Jessica's estate. In 2016, if Jessica had retained certain powers that caused the trust to be included in her estate, the beneficiary's child would receive a stepped-up cost basis at Jessica's death. This would apply the fair market value of the assets as of her date of death, potentially reducing the child's capital gains tax liability when the assets are eventually sold.

Scenario 2: When Estate Tax Inclusion Does Not Occur

If the assets are excluded from Jessica's estate, meaning no estate tax inclusion occurs, the stepped-up cost basis would not apply. In this case, the child would inherit the assets at the original cost basis paid by the trust. This would result in a higher capital gains tax liability when the assets are eventually sold, assuming the fair market value of the assets is higher than the original cost basis.

Conclusion

The outcome of a stepped-up cost basis in the case of a beneficiary's death before receiving a distribution from an irrevocable trust is contingent on whether the trust assets pass through the decedent's estate. It is crucial for trust drafters and beneficiaries to carefully consider the powers within the trust and the potential tax implications of estate tax inclusion. Legal and financial professionals should be consulted to ensure the trust's design aligns with the intended goals and minimizes tax liabilities for beneficiaries.

Frequently Asked Questions

Q: What is an irrevocable trust?

A: An irrevocable trust is a legal entity created by a settlor where the trust assets are held for the benefit of one or more beneficiaries. The key feature is that once the trust is created, it cannot be altered or terminated by the settlor without the beneficiaries' or trust beneficiaries' consent, making it a crucial tool in estate planning and avoiding estate taxes.

Q: What is a stepped-up cost basis?

A: A stepped-up cost basis refers to the federal income tax rule where the cost basis of inherited property is reset to its fair market value at the date of the original owner's death. This can significantly reduce the capital gains tax liability for the recipient when selling the property.

Q: How can I avoid estate tax inclusion in a trust?

A: To avoid estate tax inclusion in a trust, you can:

Ensure the trust is properly drafted with no powers that allow the settlor or another party to have control over the trust assets. Utilize zeroed-out allocation clauses to take advantage of marital and generation skipping tax exemptions. Place assets in a trust that maintains a separate taxable estate and avoids inclusion in the settlor's estate.