Irrevocable trusts have long been recognized as valuable tools for protecting assets for the next generation and beyond. Assets titled in an irrevocable trust are better protected from the likes of creditors or lawsuits, and shielded from federal estate tax, and generally, state inheritance taxes.
Irrevocable Trusts: Background
Historically, irrevocable trusts were established to control and maintain family wealth, to prevent subjecting the family wealth to estate and inheritance taxes generation after generation. Until 2016, the federal estate tax exemption was just over $5 million ($5.43 million in 2015) per recipient, so keeping irrevocable trust assets out of the beneficiary’s estate was a top priority. However, with the current exemption amount ( increasing to $15 million as of January 1, 2026), keeping trust assets out of the beneficiary’s estate is not as important as in the past for many clients.
Today’s irrevocable trusts are drafted with provisions granting a general power of appointment in favor of the primary beneficiary, which allows for a “step-up” in income tax basis upon the death of the primary beneficiary. Most trusts drafted under the pre-2016 federal estate tax exemption regime do not have such a provision, and trust beneficiaries do not receive a step-up in income tax basis. So what can be done to modernize these outdated trusts?
Step-Up in Basis
A step-up in income tax basis is one of the most substantial tax benefits associated with inherited assets. When someone dies owning an asset, such as real estate, stocks, or a closely held business, the asset’s cost basis is “stepped up” to its fair market value at the time of the decedent’s death. This eliminates the unrecognized capital gains that accumulated if the asset experienced substantial appreciation during the decedent’s life. With an inheritance, the beneficiary’s basis is equal to the stepped-up basis, rather than the original cost basis of the deceased owner. As such, the beneficiary can sell the inherited asset with little or no capital gains tax due if it is sold before it further appreciates. Even if the asset does appreciate, the capital gains are significantly reduced thanks to the step-up in tax basis.
Irrevocable trusts are not traditionally eligible for stepped-up fair market value basis. When a person (the “grantor”) funds an irrevocable trust, the basis of the assets used to fund the trust is equal to the grantor’s cost basis. If the trust, or a beneficiary who receives an asset sells it, the gain and resulting taxes are going to be based on the difference between the grantor’s cost basis and the sale price of the asset. Fast forward to the next generation: if the irrevocable trust does not have the key provisions in place, when the initial generation of beneficiaries dies, the basis in the assets remains the same as the basis when the grantor transferred the assets to the trust or when the trust purchased the asset. As a result, an asset that goes unsold for several generations could result in significant appreciation, with no stepped-up basis to reduce the burden of capital gains taxes.
Trust Modification: A Case Study
There are many existing trusts that were established many years or decades ago that have doubled or tripled in value due to appreciation in asset values—stocks, real estate, closely held family businesses. For beneficiaries of those trusts, such as in the following example, the goal of the planning is often to allow for the step-up in basis of large unrealized capital gains imbedded in the trust. Because of the substantial increase in the amount of the federal estate tax exemption in recent years, the beneficiaries often are no longer concerned about federal estate taxes as their estates are substantially below the federal estate tax exemption amount.
In setting up and maintaining estate documents like trusts, collaboration among professionals of various disciplines is essential. Being a part of a large firm I had the resources to approach the matter not just as an investment advisor, but from a comprehensive wealth management perspective, with access to virtually every area of financial expertise, from business valuations to the tax implications associated with the trust investments. But estate plans also require the input of experienced estate planning attorneys, in this case, Knox McLaughlin Gornall & Sennett, P.C. (Knox Law) based in Erie, PA, and an attorney I often work with on estate plans, Tom Hoffman.
Initially we reached out to Hoffman to confirm the beneficiary designations, but the conversation extended to the tax liabilities associated with a trust that was created under a predeceased spouse’s will. The spouse had been deceased for more than ten years. Hoffman and his colleagues, including attorneys Nadia Havard and Kenzie Ryback, proposed a solution that involved modifying the trust by granting a general power of appointment over the trust assets (without increasing federal estate tax or the applicable Pennsylvania inheritance tax due on the death of the second spouse) so that assets with unrealized gains in the trust would receive a step-up in tax basis upon the surviving spouse’s death.
The tax savings are equal to the capital gains rate times the unrealized capital gains on the date of the second spouse’s death. For example, if the trust is funded with $1 million on the date of the first spouse’s death, and it appreciated to $2 million by the death of the second spouse, the tax savings would be the combined federal and state income tax and capital gains tax. The highest marginal rate for federal capital gains tax is 20 percent; add a 3.8 percent surtax and the 3.07 percent Pennsylvania income tax for a total tax rate of 26.87 percent. Therefore, the tax savings on a $1 million step-up in basis would be about $268,700. The longer the surviving spouse lives, the greater the tax savings are likely to be.
Approval of the court
“Under Pennsylvania law, the trust instrument may allow for certain modifications, but under the terms of the trust in question, there was no mechanism to modify the trust,” Havard noted. “Because the grantor, the first spouse, was deceased, Pennsylvania law only authorizes modification of the trust with Court approval.
“Such irrevocable trusts are intended to provide tax savings and asset protection,” she explained. “The modification of the trust to save further income taxes was consistent with the material purpose of the trust. Further, all beneficiaries agreed to the modification.”
With the rising federal estate tax exemption levels, such modifications are becoming more common, Hoffman pointed out. “Modifications are not a slam dunk, but judges are becoming more accustomed to such modifications and thus, Court approval is now more routine.”
Collaboration is essential
Collaboration is essential to effective estate planning. “You need to work with a team to avoid mistakes,” Hoffman said.
Ryback added: “Teamwork comes into play at the beginning, creating the trust and assigning beneficiaries, and making other decisions in ways that provide asset protection for a family or a particular individual. But it is also important to maintain the trust which we sometimes refer to as ‘trust care and feeding.’”
“We hold annual meetings with trustees and beneficiaries,” Havard said. “It is crucial to include all professionals assisting with the trust care and feeding, including, but not limited to, the CPAs preparing the federal and state income tax returns for the trust and financial advisors assisting with the investment of trust assets in line with the terms of the trust and needs of the beneficiaries.”
It is also important to review an estate plan regularly to ensure it is accomplishing the client’s goals in light of changing regulations as well as what are almost always evolving circumstances surrounding the client and family. Keeping plans current can require expertise from various disciplines, which makes collaboration among the professionals serving the client key to ensuring the client achieves their goals and preserves their legacy.
Beyond tax savings
Multigenerational asset-protection trust planning is similar in purpose to insurance. While trust planning cannot prevent premature deaths, divorce, or other turmoil that can affect a family, it can help mitigate their impact on the lives of the beneficiaries.
“Initially we used irrevocable trusts solely for the tax savings,” Hoffman said. “But we found that while our clients appreciate the tax planning, they appreciate the non-tax benefits of the trust even more. If they remarry, they can protect the assets from a past or future spouse. Or if they need long-term care, the assets of the trust are not subject to Medicaid spend-down requirements or Medicaid estate recovery. Or if the surviving spouse engages in bad business transactions, the creditors can’t recover from the trust. The irrevocable trust is a multigenerational, multi-situational planning tool.”
The outcome of our collaboration with Knox Law and our CPA partners was not only a significant tax savings for our client, but also a clear example of the value created when financial advisors go beyond portfolio management and act as strategic wealth partners.
For more information on trust modification or to schedule a meeting to create or review an estate plan, call me at 814-836-5776, or email me at srinn@hbkswealth.com.
Important Disclosure
The information and examples included in this document are for general, educational, and informational purposes only. It does not contain any financial or investment advice and does not address any individual facts and circumstances. As such, it cannot be relied on as providing any financial or investment advice. If you would like financial or investment advice regarding your specific facts and circumstances, please contact a qualified financial advisor.
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