Practical advice on current issues.

• Author: Wagner, Howard

Estates, Trusts & Gifts

IRS signals it will challenge IDGT basis step-up at death

The IRS recently published Rev. Rul. 2023-2, which publicly announced that the Service will be challenging a basis step-up for assets in intentionally defective grantor trusts (IDGTs).The ruling concludes that if the assets of an IDGT are not included in the grantor's gross estate upon his or her death, those assets do not get a basis step-up.

Nature and purpose of IDGTs

An IDGT is typically used to transfer income-producing and highly appreciating assets out of an estate. The unique characteristic of IDGTs is that they are treated differently for estate and gift tax purposes than they are for income tax purposes.

Establishing an IDGT requires the grantor to settle an irrevocable trust in which the grantor retains a certain power or powers that intentionally cause the trust to be treated as a grantor trust. Status as a grantor trust essentially makes the trust invisible for income tax purposes, and the trust's income is taxed to the grantor.

For estate and gift tax purposes, the trust is very much visible. The transfer of assets to the trust is treated as a gift, potentially triggering gift tax. Moreover, the assets are treated as belonging to the trust, not the grantor, thus escaping estate tax at the grantor's death.

While most practitioners have concluded, as the IRS has, that there is no step-up in basis for assets in an IDGT due to the property's not being included in the grantor's estate, some practitioners advanced the idea that a basis step-up should be allowed. Their argument is based on the premise that the grantor owns the property for income tax purposes, and since the grantor's death ends such ownership, it is the death that triggers the asset transfer as if by bequest or devise, and, thus, a basis step-up should be allowed.

Rev. Rul. 2023-2 clarifies IDGT treatment

Under Sec. 1014, the basis of property in the hands of a person acquiring it from a decedent is the fair market value of the property as of the date of the decedent's death.

In Rev. Rul. 2023-2, the IRS confirmed that the basis step-up under Sec. 1014 does not apply to assets gifted to an irrevocable grantor trust. If trust assets are not included in the grantor's gross estate for federal estate tax purposes, a basis step-up is not appropriate. In such cases, the assets of the grantor trust are not considered as acquired or passed from a decedent by bequest, devise, inheritance, or otherwise within the meaning of Sec. 1014(b), and therefore Sec. 1014(a) does not apply. For property to receive a basis adjustment under Sec. 1014(a), the property must be acquired or passed from a decedent.

This issue is not new, and, in fact, there have been previous proposals to address it. In November last year, the IRS announced in its Priority Guidance Plan that the present ruling was coming early this year. They have now held to that promise.

Looking ahead

It is advisable for clients to contact their tax adviser to evaluate what the revenue ruling means if they settled an IDGT and took a step-up in basis, and determine what options are available should the ruling negatively affect the IDGT planning. One thing tax preparers will need to consider is whether continuing to take a position that a stepped-up basis is available rises to the level of substantial authority so that a return can be filed without Form 8275, Disclosure Statement. Consider the following examples:

Example 1: At the death of the grantor of an IDGT in 2021, the beneficiaries claimed a step-up in the basis of C corporation stock. Half of the stock was sold in 2021, reflecting reduced gain due to the stepped-up basis. The remaining stock is sold in 2023. Even if the taxpayer does not reflect a stepped-up basis for the stock sold in 2023, they would need to consider any potential exposures for the 2021 tax year as a result of Rev. Rul. 2023-2. Example 2: At the death of the grantor of an IDGT in 2019, the beneficiaries claimed a step-up in the basis of a partnership interest. A Sec. 754 election was made, and the step-up is reflected as a 15-year Sec. 197 deduction under Sec. 743. If the partnership continues to reflect the Sec. 743 adjustment with the step-up, it would need to consider if the position still is at a substantial authority level for the return to be filed without Form 8275 disclosures. Example 3: At the death of the grantor of an IDGT in 2019, the beneficiaries claimed a stepped-up basis in a parcel of real estate. In 2021, the real estate was sold in an installment sale under Sec. 453. The sale provided for 10 annual payments of $1 million beginning in 2021 through 2030. How should the sellers compute the gross profit percentage on the remaining installment payments if they want to follow the guidance of the revenue ruling? Ultimately, this issue may be resolved by the courts, and there is no guarantee that the IRS will prevail. Again, clients should contact their tax adviser to evaluate what the revenue ruling means if they settled an IDGT claiming a stepped-up basis, and determine what options are available if the IDGT planning is negatively affected.

From Peter Trieu, J.D., San Francisco

Foreign Income & Taxpayers

Impact of the OECD global anti-base erosion model rules on GILTI

The Organisation for Economic Cooperation and Development (OECD) has been steadfast in recent years in its efforts to overhaul the current corporate cross-border tax rules. The recent focus is in response to the digital economy and current operational trends of multinational organizations in low-tax jurisdictions. This focus is primarily designed to prevent race-to-the-bottom scenarios with respect to income tax rates within low-tax jurisdictions as well as shifting of tax collection of profits outside jurisdictions in which they are generated.

In October 2021, 137 countries of the OECD Inclusive Framework on Base Erosion and Profit Shifting initially agreed to a two-pillar reform framework. Pillar One generally aims to reallocate profits to countries where a large multinational's clients are located, known as market jurisdictions. Pillar Two, the global anti-base erosion (GloBE) rules, proposes three interconnected tax rules: the qualified domestic top-up tax (QDMTT), the income inclusion rule (IIR), and the undertaxed profits rule (UTPR). Each rule may be instituted by Inclusive Framework member countries to meet the framework requirements. The Pillar Two rules would apply to multinational enterprise (MNE) groups with total consolidated revenues above [euro]750 million in at least two of the four years immediately preceding the tested tax year.

General mechanics of the Pillar Two rules

Each rule analyzes a constituent entity's effective tax rate (ETR) to determine potential top-up tax liability within a specific operating jurisdiction under the Pillar Two framework. The top-up tax is generally calculated based upon a top-up tax percentage, which is defined as the excess of the proposed global minimum ETR of 15% over the respective ETR in the jurisdiction. The top-up tax percentage, if greater than zero, is then applied to an amount of excess profit equal to net GloBE income minus a carve-out for tangible assets and payroll costs within the jurisdiction.

GloBE income or loss is based on the financial accounting income or loss of each constituent entity in the accounting standard of the MNE's ultimate parent entity, with certain necessary adjustments under the GloBE rules. GloBE income or loss is further allocated to permanent establishments or through flowthrough entities if necessary.

A QDMTT is generally defined as a minimum tax that is included in a jurisdiction's domestic law and that: (1) determines excess profits of a constituent entity; (2) increases any domestic tax liability on such profits to the minimum jurisdiction rate (e.g., at least 15%) for a fiscal year; and (3) is implemented and administered consistently with the GloBE rules and related guidance. The QDMTT rules generally operate in a way to reduce the amount of top-up tax that is payable under the IIR and UTPR rules. A QDMTT could apply to purely domestic groups, i.e., groups with no foreign subsidiaries or branches, or those that do not meet the [euro]750 million threshold.

The IIR, the primary Pillar Two rule, imposes a minimum tax of 15% on the ultimate parent entity or intermediary parent entity in proportion to its ownership interests in any constituent entities that have excess profit taxed at a rate lower than 15%. The UTPR functions as a backstop to constituent entities with low-taxed income held through a chain of ownership that does not result in the low-taxed income being included under an IIR (e.g., dilutive ownership interests). In such case, the UTPR requires an adjustment that increases tax at the subsidiary level, typically in the form of a denial of a deduction. The adjustment applicable to MNE group entities is the amount necessary to meet the top-up tax threshold (i.e., as calculated under the IIR). Then, the amount is allocated among UTPR implementing jurisdictions, based on a formula, in proportion to the relative shares of assets and employees.

The OECD initially desired that the IIR and the UTRP would be effective from 2023 and 2024, respectively. However, these rules have not come into effect in any jurisdictions. While many Inclusive Framework member countries have announced plans to implement a minimum tax under the GloBE rules, only a few have passed GloBE legislation.

Potential impact of the Pillar Two framework on GILTI and US shareholders

Countries with a current minimum tax regime on foreign earnings (e.g., the United States), are required to update their rules to substantially meet the general requirements above. The U.S. global intangible low-taxed income (GILTI) regime is designed to tax the profits of foreign corporations owned more than 50% by U.S. shareholders that exceed a certain base...