Proper IRD Planning Can Preserve Family Wealth

Income in respect of a decedent (IRD) crops up in all sizes of estates. However, strategies exist for minimizing or eliminating the double tax IRD items generally bear. This article provides examples and planning strategies for minimizing IRD.

Caroline D. Strobel, Ph.D., CPA
Professor of Accounting
The Darla Moore School of Business
University of South CarolinaColumbia, SC

 Paul J. Streer, Ph.D., CPA
Professor of Accounting
J.M. Tull School of Accounting
The University of GeorgiaAthens, GA

For more information about this article, contact Dr. Strobel at strobel@darla.badm.sc.edu .

Executive Summary

• IRD refers to gross income items to which a decedent was entitled at death, but were not properly includible in taxable income for the year of death (or prior years) under the decedent's accounting method.

• Proper IRD planning can mitigate the excessive tax burden that might otherwise apply.

• One effective strategy for dealing with IRD items is to avoid them to the extent possible.

Normally, the income tax basis of inherited property is the value at which it is included in a gross estate; under Sec. 1014(a)(1), this is the date of death (DOD) fair market value (FMV).¹ However, if alternative valuation is validly elected, the property's FMV at the earlier of its date of disposition or six months after the decedent's death controls.² For appreciated property, the basis step-up rule allows any appreciation in the property's value that occurred while held by the decedent to completely escape Federal income taxation (even when no estate tax is payable). Thus, elderly individuals approaching death have a powerful incentive to retain appreciated property.

IRD

Unfortunately, not all appreciated property included in an estate receives this favorable basis treatment. Items of income in respect of a decedent (IRD) do not receive a basis step-up and, thus, are potentially subject to both estate and income taxes. Under Regs. Sec. 1.691(a)-1(b), IRD includes:

1. All accrued income of a cash-method decedent (e.g., accrued bond interest, declared but unpaid dividends and accrued rents).

2. For an accrual-method decedent, income accrued solely by reason of the decedent's death (e.g., death benefit or lawsuit claim).

3. Income to which the decedent had a contingent claim at his DOD (e.g., lawsuit claim or commissions on premiums paid after the DOD).

4. Any retirement benefits the decedent owned.

Many estates include one or more IRD items. Fortunately, proper planning for IRD can mitigate the excessive tax burden that might otherwise apply.

Definition and Treatment

According to Regs. Sec. 1.691(a)-1(b), IRD refers to gross income items to which a decedent was entitled at death, but were not properly includible in taxable income for the year of death (or prior years) under his accounting method. There need be no legally enforceable right to receive the IRD item, but the payment must clearly represent a right of receipt that arose prior to death (e.g., uncollected salary of a cash-basis taxpayer and/or the income or gain on an installment sale).

Like all assets owned by a decedent at death, IRD is fully includible in the gross estate; basis of an IRD item carries over from the decedent. Consequently, any inherent appreciation at death triggers taxable income on collection, subsequent sale or other disposition. Sec. 691(a)(3) provides that an IRD item has the same character in the transferee's hands as it had in the decedent's.

Under Sec. 691(c)(1)(A), a recipient who includes IRD in gross income can take an itemized deduction for estate tax paid by the decedent's estate on the item, thus providing limited relief from double taxation.³ The deduction is not subject to the Sec. 68 2%-of-adjusted-gross-income (AGI) limit, but the itemized deduction phaseout rules apply.⁴ An IRD recipient may deduct a pro-rata portion of the total Federal estate tax paid attributable to the inclusion of IRD items (net of related expenses and deductions in respect of a decedent (DRD)) in the decedent's estate. According to Sec. 691(c)(2) and (3), this incremental amount is the excess of the Federal estate tax actually incurred over that calculated by excluding IRD items (less DRD and related expenses) from the estate tax computation.⁵ 

Example 1: H, a cash-basis taxpayer, sold land under an installment contract in 2001 that he had held as an investment for 10 years. He did not elect out of the installment method. H's basis was $50,000; the sales price was $360,000. Under the buyer's note, H is scheduled to receive eight annual payments of $45,000 each (plus 10% interest) beginning in 2003. H died in 2002, when the note's FMV was $360,000. His gross estate must include the note's FMV. If P, H's daughter and sole heir, receives the note from H's estate in 2002, she will report each installment payment received. H's gross profit percentage (GPP) for installment-sale purposes is gross profit/selling price; this is ($360,000 –  $50,000)/$360,000 or 86.11%. Beginning in 2003, P will report $38,750 ($45,000 x 86.11%) of long-term capital gain (plus accrued interest received) on receipt of each installment payment. She will also be entitled to deduct (as an itemized deduction) a portion of the estate tax paid by H's estate attributable to the inclusion of the installment note's income element.⁶ (In 2003, the IRD will be both the capital gain portion of the installment receivable, as well as the interest that accrued until H's death.)

 

Types

Many other types of assets typically included in a cash-basis decedent's estate qualify as IRD, such as:

1. Unpaid salary and related fringe benefits accrued at death (Regs. Sec. 1.691(a)-1(b)(1)). The presence of an absolute legal obligation to pay the decedent does not bar IRD status.⁷

2. Fees and commissions from services performed by the decedent before death, even though the amount to be received is uncertain (Regs. Sec. 1.691(a)-2(b)).

3. Retirement plan benefits and other deferred-compensation arrangements in excess of the decedent's tax basis.⁸

4. Declared but uncollected dividends payable to a decedent who was a holder of record at his DOD.

5. Interest due the decedent at his DOD, including accrued interest on U.S. savings bonds not reportable by the decedent before his DOD (Regs. Sec. 1.691(a)-2(b), Example 3).

6. Sale gain from property disposed of by the decedent before death, but unreceived. The decedent must have substantially fulfilled all of the substantive requirements for completion of the sale and be unconditionally entitled to the proceeds.⁹

7. Certain receivables due from partnerships, S corporations and sole proprietorships. The income tax basis of inherited partnership and S interests is reduced by an heir's share of IRD items (e.g., cash-basis accounts receivable on the entity's books).

8. Unpaid alimony a decedent was entitled to receive at his DOD.¹⁰

Avoiding IRD

Savings Bonds

One effective strategy for dealing with IRD items is to avoid them to the extent possible. For example, an executor can elect under Sec. 454(a) to report accrued U.S. savings bond interest on a cash-method decedent's final Federal income tax return (provided the decedent did not make the election during life). The acceleration of taxable income into the decedent's final return can be particularly beneficial if death occurs early in the tax year (i.e., with insufficient taxable income to absorb exemptions and deductions) or the bond interest will be taxed at a lower rate to the decedent than to the estate or beneficiaries.

The election eliminates IRD; the bonds' bases in the beneficiaries' hands will be the DOD FMV. Further, beneficiaries will be taxed only on bond interest accruing after the decedent's death. Beneficiaries are not bound by the executor's election and can report interest accruing in the future under the cash method.¹¹

Retirement Account Balances

Older individuals with large retirement balances accumulated in Keogh, Sec. 401(k) or 403(b) or regular IRA accounts should carefully evaluate whether to continue to maximize account contributions. Because the entire account balance is an IRD item, the combined income and transfer tax bill can be excessive if an individual passes undistributed benefits to heirs other than the surviving spouse.¹² This is also true for other types of deferred-compensation arrangements.

Example 2: G, a 65-year-old single physician in the 45% combined Federal and state income tax bracket, had a $2 million balance in his Keogh plan at the end of 2000. In 2001, he contributed an additional $30,000 to the plan, producing a $13,500 income tax benefit ($30,000 x 45%). If G died immediately after making the contribution, his estate would have paid an additional $23,925 of Federal and state transfer taxes (55% x ($30,000 + $13,500)) on the $30,000 account balance (plus income tax savings), assuming a 55% marginal estate tax rate and an 8% state death tax credit rate.¹³ If G's heirs are also in the 45% bracket, and choose to receive a lump-sum distribution of the Keogh plan balance, they will pay $7,155 (45% x ($30,000 – $14,100 IRD deduction)) more income tax in the year of receipt (assuming full use of the $14,100 IRD deduction ($30,000 x 47%)), because of the presence of an additional $30,000 IRD. Consequently, of the original $30,000 Keogh plan contribution, only $12,420 ($30,000 + $13,500 – $23,925 – $7,155) is available for the beneficiaries' use.

If G had not made the $30,000 contribution and instead spent the after-tax funds, he would have received $16,500 ($30,000 x (1 – 45%)), $4,080 more. Alternatively, he could have made an outright gift of $10,000 each to three heirs. No transfer tax consequences would result, because of the Sec. 2503(b) annual gift tax exclusion.¹⁴ The same $4,080 of net benefit would exist and G would have successfully passed on a portion of his wealth to younger heirs. This gifting program could be implemented annually in lieu of Keogh plan contributions.

However, if the heirs choose to receive their shares of the retirement account balance in periodic distributions, the present value of the income tax liability they incur can be substantially reduced and the double tax effect blunted. Further, retirement account holders may benefit from proposed regulations issued in January 2001.¹⁵ The proposed regulations make substantial revisions in the required minimum distribution (RMD) rules for distributions made after age 70¹/₂ and for accounts that pass to an estate or beneficiary following death. The income tax effect may be reduced by extending the period over which penalty-free distributions can be made.

In G's case, each additional dollar withdrawn from the account leaves him 55% (145%) to consume or gift. Absent the withdrawal, the combined transfer tax (Federal and state) and income tax, assessed on that dollar would be sizable. The total tax rate would be 79%: 55% of combined estate tax, plus 24% (45% x 53%) of beneficiary income tax.¹⁶ Thus, G's heirs can consume only 21% of each retirement account dollar. The early withdrawal of funds gives G and his family a 34% increase in consumable resources ((1 – 45%) 221%).

This advantage will be offset somewhat by the loss of the tax-deferred earnings on the withdrawn funds. The longer the time span between the date of withdrawal and the DOD, the greater the potential amount of lost earnings. If G designates a younger family member as a beneficiary, the deferral period could be substantially extended under the new RMD rules. If grandchildren are designated heirs, their remaining life expectancies will be quite long and earnings will continue to buildup in the tax-deferred account. This accumulation is likely to more than offset any advantage that may accrue from taking early distributions, but would need to be managed so as to not create any GST tax liability.

Given the new RMD rules, wealthy retirees should carefully consider whe-ther there is a benefit from even a moderate acceleration of retirement account distributions. This will hinge on the facts and circumstances. However, this planning option should be considered and evaluated, when appropriate. Automatically maximizing retirement account deferral opportunities without periodic reevaluation is ill-advised.

Disposition of IRD Items at Death

It is not always possible (or desirable) for a beneficiary to avoid the receipt of IRD items. If IRD items will be included in an estate, the objective should be to minimize the tax cost incurred by the recipient beneficiaries. One way to accomplish this is to make specific bequests of the IRD assets to beneficiaries in low tax brackets. Otherwise, both high- and low-income-bracket beneficiaries will often be entitled to a pro-rata portion of each IRD item; a tax savings opportunity will be lost. This strategy may also require that non-IRD items be bequeathed to higher-income heirs or that another allocation be made to accomplish the decedent's asset-division objectives. This can be beneficial even if the decedent does not have a taxable estate; the potential tax advantages can be very worthwhile.

Example 3: K owned a $150,000 installment note (from the sale of long-term capital gain property) at his DOD; his estate was in the 55% bracket. The GPP on the installment note is 33¹/₃% (i.e., $10,000 of gross income must be reported annually on a pro-rata basis when the $30,000 required payments are received in each of the next five years). If K bequeathed the note to his married nephew A, who itemizes and is in a 15% combined Federal and state bracket, the total income tax liability after collection of the five installments will be $3,975 (($50,000 – $23,500 IRD deduction) x 15%).¹⁷ If instead B, a nephew in a combined 45% bracket, had received the note, the tax liability would decrease to $1,925 (($50,000 x 25%) – ($23,500 IRD deduction x 45%)).¹⁸ Regardless of which beneficiary receives this IRD item, K's estate tax payable on the income element of the installment note remains at $27,500 ($50,000 x 55%).

If an individual plans to make charitable transfers at death, he can bequeath IRD items to charity and non-IRD items to heirs. In addition to the psychological satisfaction gained from assisting a worthy charitable endeavor, the tax bill will be minimized. All transfer tax will be avoided because of the Sec. 2055 charitable deduction for the net amount of property passing to the charity.¹⁹ Further, the heirs can gain a substantial benefit—they are freed from the income tax liability they would otherwise incur from receiving IRD items instead of other estate assets.

Example 4: The facts are the same as in the Example 3; in addition, K's will contained a $150,000 bequest to his church. If he bequeathed the installment note, there is no estate tax or income tax. On the other hand, the note in B's hands would bear a $1,925 cumulative tax burden (($50,000 IRD x 25%) – ($23,500 IRD deduction x 45%)) when payments are received. This liability can be completely avoided by making a specific bequest and transferring non-IRD assets to beneficiaries. This planning strategy puts a substantial amount of additional after-tax resources in the heirs' hands.

Under the new RMD rules, if some portion of a retirement account balance is designated for charity and the distribution is made before December 31 of the year following the year of death, younger-generation beneficiaries will be able to use their own life expectances to calculate RMDs on their shares. For donations of qualified-plan balances, it is critical that this be reflected in the plan's beneficiary designation document.

Maximizing IRD Deduction Benefits

Making proper use of the IRD deduction for estate taxes paid is an effective way to mitigate the double-tax effect. Noncharitable beneficiaries should be carefully selected to preserve the deduction's benefits. If low-bracket beneficiaries have insufficient other deductions to enable them to itemize, the IRD deduction will either be diluted or lost. In Example 3, A's complete loss of the deduction increases the total tax liability by $3,525 ($23,500 x 15%). Thus, a lower-bracket heir would not be the preferred choice to receive the installment note.

On the other hand, if B is in the itemized deduction phaseout range, up to 80% of the deduction can evaporate. If the full phaseout applies, he will pay $8,460 additional income tax ($23,500 x 80% x 45%). In that case, the installment note's profit element bears a total $37,885 tax (combined estate tax of $27,500 ($50,000 x 55%) + $10,385 income tax (($50,000 x 25%) – ($23,500 x 20% x 45%))). Obviously, B should not receive the installment note if there is another alternative.

No matter which beneficiary is chosen to receive IRD, the estate executor or administrator should inform him of his right to a share of the deduction for estate taxes paid. Beneficiaries should also receive the specific information needed to compute and claim their proper share of the total IRD deduction in the year the IRD income is reportable. Failure to communicate this information could cause the deduction to be completely overlooked. 

Example 5: The facts are the same as in Example 3, except that K's estate included $2,300,000 of net IRD items; his combined Federal and state estate tax liability was $3,200,000. If the IRD items had not been included, his combined Federal and state estate tax liability would have been $1,935,000. The IRD deduction is computed only on the Federal estate tax attributable to the net IRD; it is $937,000 ($2,567,000²⁰ – $1,630,000²¹). The beneficiary of K's installment note (which incorporates $50,000 of IRD over five years) will be entitled to $20,370 in IRD deductions (($50,000/$2,300,000) x $937,000) and can deduct a pro-rata portion of the $20,370 in each tax year an installment payment is actually received.

The existence of the IRD deduction and the amount available should be communicated to a recipient on a timely basis by the estate fiduciary. This will ensure that the beneficiary will use the deduction timely in his income tax computation.

Conclusion

IRD items are taxed twice, once in the estate and again when included in the estate's or beneficiary's income. Most estates have IRD items, because taxpayers are on the cash basis and an estate is essentially valued on an accrual basis to determine the decedent's net worth. When an estate contains a significant amount of IRD, careful planning for the final disposition of affected assets can significantly reduce the double-tax effect and maximize the ultimate benefits family members receive.