Do Assets in an Irrevocable Trust Get a Step-Up in Basis?

Joan's Question: If Mom's Trust Is Irrevocable, Do the Kids Still Owe Tax?

Joan is 81 and lives on Longboat Key. She is a composite client, not a real person, but her situation is one I see often in my practice. Back in 2015, she moved a block of stock she had owned since the 1990s into an irrevocable trust for her children. The stock has appreciated substantially since then. Joan's family assumes that when she passes away, the kids will inherit that stock the same way they would inherit anything else: with a fresh, stepped-up basis equal to the value on her date of death, wiping out decades of paper gain for capital gains tax purposes.

An irrevocable trust is one the person who creates it cannot simply revoke or amend on their own. That is precisely what lets it move assets out of the maker's estate for creditor protection, Medicaid planning, or estate tax purposes. But that same feature, moving assets out of the estate, is exactly what can also cost a family the step-up in basis. Whether Joan's kids get that tax benefit depends entirely on how her trust was built.

The Basic Rule: Basis Follows Estate Inclusion

Under the federal tax code, property a person receives from someone who has died generally gets a new basis equal to its fair market value on the date of death. That is the step-up most families count on, and it is a huge benefit for anything that has appreciated significantly over the years.

But that rule only applies if the asset is included in the deceased person's gross taxable estate. If Joan gave the stock away as a completed gift years ago, and the trust was structured so the stock is not counted as part of her estate when she dies, the stock does not get a step-up. Instead, it keeps a carryover basis, meaning the trust (and eventually the kids) inherit Joan's original 1990s purchase price for calculating gain.

• Included in the estate (through a retained interest, a retained power, or certain other triggers) = step-up in basis at death.
• Fully outside the estate because it was a completed, irrevocable gift = no step-up, carryover basis instead.

This is the single most important design question for any irrevocable trust holding appreciated assets, and it is often overlooked when families focus only on creditor protection or Medicaid eligibility.

The IRS Settled the Debate: Revenue Ruling 2023-2

For years, some practitioners argued that assets in a certain type of irrevocable trust, known as a grantor trust (where the person who created the trust still pays the income tax on trust earnings during their lifetime), might get a step-up at death even if the assets were outside the taxable estate. The idea was that because the grantor was taxed on the trust's income all those years, the assets should be treated as still belonging to the grantor for basis purposes too.

The IRS closed that door. In Revenue Ruling 2023-2, issued in March 2023, the IRS confirmed that completed gifts to an irrevocable grantor trust do not receive a step-up in basis at the grantor's death, unless the assets are also included in the grantor's gross estate. Paying income tax on the trust's earnings during life does not, by itself, pull the assets back into the estate for basis purposes. The two systems, income tax and estate tax, are simply treated separately.

This ruling did not change the underlying law. It confirmed what most careful estate planning attorneys already believed, but it removed the ambiguity that some had hoped to use to their clients' advantage.

How Some Irrevocable Trusts Are Built to Keep the Step-Up

Not every irrevocable trust loses the step-up. Some are deliberately designed so the assets remain includable in the grantor's estate, trading away a bit of asset protection or estate tax planning in exchange for the income tax benefit. Common features that can cause inclusion include:

• A retained life estate, where the grantor keeps the right to income or use of the property for life.
• A retained power over who receives the property or when.
• A swap power (sometimes called a power of substitution), which lets the grantor exchange other assets of equal value for the low-basis assets in the trust. If the grantor swaps in cash or high-basis property and takes back the appreciated stock before death, that stock may then be part of the estate and eligible for a step-up.

Swap powers are a widely used tool precisely because they give a family flexibility. During life, the trustee can pull low-basis, highly appreciated assets like Joan's stock back to the grantor (in exchange for equivalent value) so that a step-up becomes available at death, while still leaving most of the trust structure intact for its other purposes.

Joan's Fix: Can an Old Trust Be Changed Now?

Joan's 2015 trust is over a decade old, and it was not drafted with a swap power or any deliberate inclusion strategy. The good news is that irrevocable does not always mean unchangeable. Florida law, under the Florida Trust Code (Chapter 736), allows irrevocable trusts to be adjusted in several defined ways:

• A nonjudicial settlement agreement among the trustee and beneficiaries, for certain types of changes.
• Judicial modification, asking a Florida court to approve a change.
• Decanting under section 736.04117, where the trustee pours the trust's assets into a new trust with updated terms.
• Appointing or using a trust protector, if the trust document allows one, to modify certain provisions.
• Modification by consent of the settlor and all beneficiaries, while the settlor is still living.

Because Joan is still living and her children are cooperative, her attorney can review whether her trust, or a decanted replacement trust, could add a swap power or another inclusion feature going forward. This would not undo the asset protection Joan originally sought, but it could meaningfully improve the income tax outcome for her children. Whether any of these paths make sense depends on the exact language of Joan's 2015 trust, her state of health, and her family's goals, which is why this kind of trust needs individualized review rather than assumptions based on someone else's plan.

Sources

• Internal Revenue Service, Revenue Ruling 2023-2, March 30, 2023
• Baker Tilly, 'IRS: No basis step-up at death for irrevocable grantor trust assets,' May 27, 2026
• The Tax Adviser, 'Rev. Rul. 2023-2's impact on estate plans,' November 1, 2023
• American Bar Association, 'Grantor Trust Gambits,' Fall 2024

This article is for general informational purposes only and does not constitute legal advice, nor does reading it create an attorney-client relationship. Florida estate, elder, probate, and real estate law are fact-specific and change over time. Consult a licensed Florida attorney about your individual circumstances. Arthur Simpson, Esq. is licensed to practice law in the State of Florida. Attorney advertising.