When I first got into tax, I learned one simple rule to always follow: if you think of some clever way to avoid or reduce tax that hasn’t been done before, you haven’t found the reason why it won’t work.

There are a lot of very smart tax attorneys out there who are trying to figure out something new, and yet there’s very little innovation.  Almost all techniques that we use are incremental variations of an older technique that’s been tried and tested.

Whenever a new concept or idea comes our way, the good tax attorney will spend a good amount of time researching it and trying to understand it, preferably with a critical mind that’s looking for reasons it won’t work.  Every once and a while a new technique comes out that established tax specialists look at in disbelief.  Unfortunately, there are plenty of advisors who are not as suspicious or rigorous, who take the optimistic approach, and perhaps lead their clients astray.

This year, three dubious techniques that some less cautious advisors have promoted are now coming to an end.

Step-Up in Basis versus the Estate Tax

Wealthy individuals who plan ahead are faced with a choice for their heirs: pay the capital gains tax or pay the estate tax.

Assets that are in your estate when you pass away receive a step-up in basis, meaning that your heirs don’t need to pay capital gains tax when the assets are sold.  Those assets are subject to the estate tax.  There are ways to remove assets out of your estate, reducing the estate tax liability, but forfeiting the step-up in basis. 

Conceptually, the reason is straightforward – (1) to get the step-up in basis, the asset must transfer due to your death and (2) if an asset transfers due to your death, it’s subject to the estate tax.  Specifically, IRC 1014 grants a step-up in basis to the person “acquiring the property from a decedent or to whom the property passed from a decedent” while IRC 2031 calculates an estate tax on the gross estate.

In recent times several tax and estate planning attorneys have published about techniques, and promoted structures, that would allow the client to have it both ways – to remove an asset from the estate while also providing a step-up in basis.  The argument notes a difference between IRC 1014(b)(1) which grants a step-up to “property acquired by bequest, devise, or inheritance, or by the decedent’s estate” and IRC 1014(b)(9) which grants the step-up to “property acquired from the decedent by reason of death, form of ownership, or other conditions… if by reason thereof the property is required to be included in… the decedent’s gross estate.  The argument is that 1014(b)(9) requires inclusion in the gross estate, and 1014(b)(1) does not, and therefore assets that are acquired by bequest, devise, or inheritance that are not included in the gross estate get a step-up.

Only a minority of estate tax attorneys promoted this, as most attorneys will acknowledge that it is not a good argument.  “bequest, devise, or inheritance” are each asset transfers from a decedent.  A bequest is personal property given in a Will, a devise is real property given in a Will, and an inheritance is received through intestacy.  All three refer to assets owned by the decedent up to the moment of death, and therefore part of the decedent’s taxable estate. 

The attorneys who claim it is possible to have it both was look to the discrepancy between Subpart E (IRC 671-679), which determines whether an individual is treated as the owner of property for income tax purposes, and IRC 2031-2045, which determines whether the assets are part of the taxable estate.  Tax planning often hinges on these differences, allowing assets to be placed In a trust that is removed from the estate while still being taxed to the individual.  However, the key issue is the very title of Subpart E is titled “Grantors and Others Treated as Substantial Owners” – it does not say the grantor is the owner, but that the grantor is treated as the owner.  Likewise, IRC 678 allows someone other than the grantor to be treated as the owner.  One proponent said that “you own those assets up until the moment you die for income tax purposes…. You, the individual, at your death have for the first time transferred those assets”, which is disingenuous, considering that at the same time the tax attorney is claiming that the assets are not owned by the person for estate tax purposes, and at the time a gift tax return had been filed with the IRS stating those assets were transferred.   

Luckily, at least one of those proponents stated that the attorney would also be “advising the client that the IRS will fight the issue”, because the IRS recently issued Revenue Ruling 2023-2, stating definitely that the IRS’s position is that assets that are not included in the gross estate will not receive a step-up in basis.