Kerry Pulliam
Your Guide to Undoing Forfeited Step-Up in Basis

By Kerry W. Pulliam, CFP, AEP, CEPA, Apogee Capital Resource Group

 

Introduction: A New Era for Estate Planning – The "One, Big, Beautiful Bill" and the Enduring Importance of Basis

 

The landscape of federal estate and gift tax planning is once again at a critical juncture for financial advisors. With the House of Representatives passing the "One, Big, Beautiful Bill Act" (OBBBA) in May 2025, the conversation around wealth transfer has shifted dramatically. This proposed legislation, aiming to make permanent many Tax Cuts and Jobs Act (TCJA) provisions and even increase the federal estate tax exemption, signals a potential new era where federal estate tax may become a concern for fewer clients.

However, a higher federal exemption doesn't eliminate the need for sophisticated planning. In fact, it amplifies the importance of another, often overlooked, tax benefit: the step-up in basis under Internal Revenue Code (IRC) Section 1014(a). While many "successful" estate plans have been meticulously crafted to avoid probate and minimize estate taxes, some, particularly those involving certain irrevocable trusts, may have inadvertently forfeited this crucial income tax advantage.

This article, provided as a resource for financial advisors by Apogee Capital Resource Group, will explore how the OBBBA changes the planning paradigm, revisit the fundamental importance of IRC Section 1014(a), and, most importantly, provide proactive strategies – including the powerful role of cash value life insurance and Private Placement Life Insurance (PPLI) – to help your clients undo forfeited step-ups and create a "synthetic" cost basis for their heirs.

 

The Evolving Tax Landscape: The "One, Big, Beautiful Bill" and its Implications

 

Under current law, the federal estate and gift tax exemption stands at an inflation-adjusted $13.99 million per individual for 2025 ($27.98 million for married couples). A significant aspect of the OBBBA, as passed by the House, is its proposal to make the federal estate and gift tax exemption permanent at $15 million per individual (indexed for inflation) beginning in 2026. This directly addresses the scheduled "sunset" of the current exemption amounts at the end of 2025, which would have seen them revert to roughly half their current levels.

While the OBBBA still requires Senate approval and could undergo modifications, its passage in the House strongly suggests a legislative intent to maintain or even increase the federal estate tax exemption.

What does this mean for advisors?

 

  1. Reduced Federal Estate Tax Focus: For a growing number of high-net-worth clients whose estates fall below these potentially higher federal exemption thresholds, the federal estate tax may become less of an immediate concern.
  2. Heightened Capital Gains Focus: This shift dramatically elevates the importance of capital gains tax planning for heirs. If federal estate taxes are not a primary driver, preventing capital gains on highly appreciated assets becomes the paramount goal for maximizing wealth transfer.
  3. State Estate Taxes Remain Relevant: Importantly, many states maintain their own estate or inheritance taxes with significantly lower exemption thresholds (e.g., $1 million to $5 million). Therefore, strategies that cause assets to be included in the gross estate for federal purposes (to gain a step-up) might still be viable, even if they nudge an estate over a state exemption, as the federal estate tax may still be avoided. This requires careful multi-jurisdictional analysis.

 

The Forfeited Benefit: Understanding IRC Section 1014(a) and the Trust Trap

 

The heart of the issue lies in IRC Section 1014(a), which dictates that the tax basis of property acquired from a decedent is adjusted to its fair market value (FMV) on the date of death. This "step-up" erases accumulated capital gains.

 

  • The Power of the Step-Up: If your client bought stock for $100,000, and it's worth $5 million at their death, a step-up means heirs receive it with a $5 million basis. If they sell it for $5 million, their capital gain is $0. Without the step-up, they'd face capital gains tax on $4.9 million – a potentially devastating tax bill.
  • The Irrevocable Trust Trap: Many irrevocable trusts (e.g., IDGTs, SLATs) were designed precisely to remove assets from the grantor's gross estate to avoid federal estate taxes. The problem is, this exclusion from the gross estate often also prevents the asset from meeting the "acquired or passed from a decedent" test for a Section 1014 step-up. The lower original basis simply carries over.
  • IRS Confirms the Trap (Revenue Ruling 2023-2): Any lingering doubt was removed by Revenue Ruling 2023-2, which explicitly states that assets held in an irrevocable grantor trust that are not included in the grantor's gross estate for federal estate tax purposes will not receive a basis step-up at death.

 

Undoing the Forfeiture: Strategies for Creating a "Synthetic" Cost Basis

The good news is that financial advisors, in collaboration with skilled estate planning attorneys, have powerful tools to "undo" this forfeiture and create a "synthetic" cost basis for heirs. These strategies aim to either pull the asset back into the taxable estate at death or provide a tax-efficient alternative for wealth transfer.

 

  1. Grantor Retained Powers: The General Power of Appointment (GPOA)
  • The Fix: By giving the grantor a carefully drafted General Power of Appointment (GPOA) over trust assets (e.g., a testamentary GPOA allowing appointment to their estate or its creditors), these assets become includible in the grantor's gross estate under IRC Section 2041.
  • The Benefit: This inclusion, even if the estate is well below the higher OBBBA federal exemption, triggers Section 1014(a), securing the invaluable basis step-up. For clients not facing federal estate tax, this is a "free" basis adjustment. For those in states with lower estate tax thresholds, it might consolidate the estate tax burden while still providing significant capital gains relief.

2. Trust Decanting or Modification:

  • The Fix: For existing irrevocable trusts lacking GPOA or other inclusion powers, state laws on "decanting" or judicial modification may allow for the trust's terms to be amended. Assets can be moved to a new trust with the desired provisions.
  • Considerations: This is a highly complex legal maneuver requiring expert counsel and a thorough understanding of state trust law.

3. Strategic Asset Swaps (for Grantor Trusts):

  • The Fix: Many Irrevocable Grantor Trusts allow the grantor a "power of substitution" (IRC Section 675(4)(C)), enabling them to swap assets of equivalent value between their personal estate and the trust.
  • The Benefit (Synthetic Basis Creation): If the trust holds low-basis, highly appreciated assets, the grantor can use personal cash or high-basis assets to "buy" those low-basis assets back from the trust. The appreciated assets are now in the grantor's personal name and will receive a step-up at death. The cash or high-basis assets remain in the trust for its intended purpose. This effectively "rescues" the asset from the basis trap.

4. Cash Value Life Insurance: A Guaranteed "Synthetic" Basis Creator

  • The Fix: While not a direct mechanism for IRC 1014 step-up on other assets, cash value life insurance (such as whole life or universal life policies) offers a powerful and guaranteed way to create a "synthetic" step-up for wealth transfer.

The Benefit:

  • Tax-Deferred Growth: The cash value grows tax-deferred within the policy, as internal policy earnings are not currently taxable to the policyholder (inherent to policies meeting the definition of life insurance under IRC Section 7702).
  • Tax-Advantaged Access: Policyowners can typically access cash values via income tax-free loans and income tax-free withdrawals up to their basis (premiums paid), subject to the Modified Endowment Contract (MEC) rules under IRC Section 7702A.
  • Income Tax-Free Death Benefit: Most importantly, the death benefit paid to beneficiaries is generally received income tax-free under IRC Section 101(a). This means beneficiaries receive the full face value, regardless of the underlying appreciation, without capital gains tax.

 

  • Application: For clients with appreciated assets that cannot be efficiently moved back into their estate for a step-up, or for those seeking additional tax-efficient legacy planning, liquidating a highly appreciated asset (triggering capital gains) and then deploying the net proceeds into a properly structured cash value life insurance policy can convert a taxable future inheritance into a tax-free one.

 

5. Private Placement Life Insurance (PPLI): The Ultra-High-Net-Worth Solution

  • The Fix: PPLI is a sophisticated form of cash value life insurance designed for accredited investors, allowing for investment into a broader range of underlying assets, often managed by the client's existing investment managers.
  • The Benefit (Enhanced Synthetic Basis): PPLI offers the same core tax benefits as traditional cash value life insurance – tax-deferred growth (consistent with IRC Section 7702), tax-advantaged access to cash values (via loans and withdrawals up to basis, subject to IRC Section 7702A), and a generally income tax-free death benefit (IRC Section 101(a)) – but with greater investment flexibility. For ultra-high-net-worth clients holding substantial illiquid or highly appreciated alternative assets within trusts that forfeit the step-up, PPLI can serve as a powerful solution. Appreciated assets can be sold, the tax paid, and the proceeds then invested into the PPLI, effectively "washing" the basis and allowing tax-free growth and transfer.
  • Considerations: PPLI has specific suitability requirements, high minimum premiums, and involves complex legal and tax considerations.

 

Important Disclaimer for Financial Advisors

This article is provided by Apogee Capital Resource Group as a resource for financial advisors. The content is for informational and educational purposes only, designed to support financial professionals in their practice. Apogee Capital Resource Group does not provide tax, legal, or financial advice to individual clients. Financial advisors are solely responsible for ensuring the applicability and suitability of any information to their clients' specific situations, and for ensuring their clients consult with qualified tax professionals, legal counsel, and other appropriate financial professionals for personalized advice. We emphasize and encourage the critical importance of a collaborative, multi-disciplinary approach to comprehensive client planning.

 

The Advisor's Imperative: Leveraging the FLIGHT Path Framework

The changing tax landscape, particularly with the OBBBA potentially solidifying higher federal estate tax exemptions, does not diminish the need for robust estate planning. Instead, it shifts the focus more squarely onto income tax efficiency for heirs.

As a valuable resource, Apogee Capital Resource Group urges financial advisors to navigate this evolving environment by leveraging our FLIGHT Path Framework:

  • F - Foundation of Knowledge: Begin by thoroughly reviewing the client's current estate plan, asset composition (including cost basis), and overarching financial and legacy goals. This foundational understanding is critical for identifying potential step-up forfeiture issues.
  • L - Leverage Collaborative Partners: Recognize that optimizing for multi-faceted tax efficiency demands a team approach. Actively collaborate with estate planning attorneys, CPAs, insurance specialists, and other qualified professionals to ensure comprehensive and compliant solutions.
  • I - Identify Indicators & Implications: Proactively identify the red flags of a forfeited step-up (e.g., highly appreciated assets within certain irrevocable trusts) and quantify the potential capital gains tax implications for beneficiaries.
  • G - Guide Clients Through the Process: Clearly educate clients on the "forfeited step-up" challenge and the proposed strategies. Guide them through the decision-making and implementation phases with clear communication and consistent support.
  • H - Holistic Approach: Move beyond single-issue planning. Embrace a holistic perspective that considers the interplay of estate tax, income tax (capital gains), asset protection, liquidity, and philanthropic goals to truly optimize wealth transfer.
  • T - Transformational Planning & Tax Efficiency: Implement strategies that deliver truly transformational outcomes, ensuring maximum tax efficiency for the client's legacy. This includes understanding how tools like cash value life insurance and PPLI can serve as powerful "synthetic" basis creators.

By following the FLIGHT Path Framework, financial advisors can transcend traditional estate planning and deliver greater value to their clients in this complex new tax environment.

 

Maximizing Legacies in a New Tax Environment

 

The "One, Big, Beautiful Bill" may signal a less daunting federal estate tax future for many clients, but it simultaneously spotlights the enduring and significant impact of capital gains taxes on inherited wealth. By understanding IRC Section 1014 and proactively employing strategies like the GPOA, strategic asset swaps, and the powerful "synthetic" basis creation offered by cash value life insurance and PPLI, financial advisors can transcend traditional estate planning. Leveraging the FLIGHT Path Framework, you can help them ensure their clients' hard-earned wealth is transferred with unparalleled tax efficiency, preserving more for the generations to come.

Kerry W. Pulliam, CFP, AEP, CEPA

Apogee Capital Resource Group

Website: ApogeeCapitalRG.com

Email: Kerry.Pulliam@CapitasFinancial.com

Phone: 502-599-6623