Strategies for minimizing the impact of income in respect of a decedent
INSIGHT ARTICLE |
Advisers focused on private clients commonly overlook planning for the income and estate taxes on income in respect of a decedent (IRD). This item discusses issues created by IRD and presents strategies and planning insights to assist taxpayers and their tax advisers with minimizing its impact.
IRD includes items of income earned or accrued during life but not received until after death. According to the section 691 regulations and commentary over the years, IRD has four characteristics:
- The item of income would have been taxable to the decedent if the decedent had survived to receive the income;
- The income right had not matured sufficiently to have been properly included in the decedent's final income tax return;
- The receipt must be of income and not a capital asset described in section 1014(a); and
- If the item of IRD is payable to someone other than the decedent's estate, the taxpayer acceding to it must have acquired the property right solely because of the decedent's death.
The most frequently received items of IRD are compensation income, commissions, retirement income, certain partnership distributions, and payments for crops. Under section 691(a), IRD must be included in gross income by the estate or other person who acquires the right to receive the income for the tax year when received.
Even though a decedent does not receive IRD before his or her date of death, the property is still included in the decedent's estate because it is considered property in which the decedent had an interest at death, within the meaning of section. 2033. IRD does not receive a step-up in basis since the income has not been taxed on the decedent's income tax return. As such, IRD creates both estate and income tax liabilities. Section 691(c) offers some mitigation of the double taxation by allowing the IRD's ultimate recipient to reduce the amount of taxes owed through an income tax deduction for estate tax paid with respect to the IRD. This item reviews the section 691(c) calculation and methodology.
IRD represents income to the person (or entity, in the case of the decedent's estate) who receives the income. For example, deferred compensation payments often are taxed to the decedent's surviving spouse, partnership receipts are frequently taxed to the decedent's estate, and retirement income is principally taxed to the decedent's surviving spouse or designated beneficiary.
Beneficiaries of a cash-basis decedent must claim all IRD when actually received unless the income was constructively received on the decedent's date of death. By contrast, beneficiaries of an accrual-basis decedent must claim as IRD only qualified death benefits and deferred compensation owed to the decedent. The other components of income, such as interest and wages accrued on the decedent's date of death, would be reported on the final Form 1040, U.S. Individual Income Tax Return, of the accrual-basis decedent.
The examples in the regulations, as well as the case law interpreting section 691, provide the context for interpreting section 691 and determining the amount of IRD, the character of the IRD, the identity of the taxpayer required to report the IRD, and the proper tax year for reporting the IRD. The first example in the section 691 regulations concerns a decedent entitled upon his death "to a large salary payment to be made in equal annual installments over five years" (Regs. section 1.691(a)-2(b), Example (1)). In the hypothetical, the estate collects two installments, and the right to the remaining installments is distributed to the residuary legacy of the estate. In this case, two installment payments would be included in the estate's gross income, and the balance would be taxable to the legatee and included in his gross income in the year received.
O'Daniel's Estate , 173 F.2d 966 (2d Cir. 1949), presents a similar situation. In O'Daniel, a vice president and director of a large company, who had participated in the company's bonus plan, died. The amount of the decedent's bonus was not set until several months after his death. Eventually, the bonus was paid to the decedent's estate, and the Tax Court ruled that the payment was IRD. The Second Circuit agreed, stating, "The bonus was derived through rights he had acquired, which even if not fixed at the time of his death were then expectancies which later bore fruit." Such rights were passed to the estate under his will and were taxable to the estate in the year the payments were received.
Section 691(a)(4) treats certain receipts from installment sales "uncollected by a decedent" and reportable under section 453 as IRD (see Regs. Sec. 1.691(a)-5). It should be noted, however, in a typical sale to a defective grantor trust, the payments on a note the trust gave in consideration for the assets the grantor sold to the trust are disregarded since the trust is a disregarded entity. Whether Regs. section 1.691(a)-5 applies to these notes has been disputed by commentators. A majority of commentators have argued that, by definition, IRD exists only where the receipt of property is treated as if the decedent had lived and received it. Under the analytical framework created in Rev. Rul. 85-13, it can be argued that because the decedent would not have recognized income if the note were paid during life, note payments after death are not properly characterized as IRD. In other words, the income tax result should be the same as if the note had been paid before the grantor's death: no income realization in either event.
A Roth IRA distribution is an exception to the rule that retirement plan distributions are IRD. With Roth IRAs, the tax-free nature of the distributions applies to the successor in interest as well as the original account owner.
Farmers have interesting IRD questions, and some of these questions have ended up in litigation with the IRS. Another example in the regulations discusses the tax result for an apple grower who sold some of his apples to a canning factory but failed to receive payment before death (Regs. section 1.691(a)-2(b), Example (5)). The grower had been negotiating to sell additional apples to another buyer but had yet to enter into a contract. The regulations provide that the gain realized upon receipt of payment from the canning factory is IRD to the decedent's estate. The sale consummated between the second buyer and the executor of the decedent's estate, however, does not qualify as IRD, even though the apples had been grown and were ready for sale at the time of death.
Lastly, under section 706, partnership income attributable to the period before the decedent's death should be included in the partner's final income tax return. Partnership income attributable to postmortem periods will be included in the income tax return of the successor to the deceased partner's interest (usually the estate). Section 691(e) cross-references section 753, which provides that section 736(a) payments are IRD. Section 736(a) includes payments a partnership made in liquidation of a retired or deceased partner's interest in excess of those made under section 736(b), which are payments for a partner's interest in partnership property.
Generally speaking, section 736(a) payments are for income, and section 736(b) payments are for property. In a service partnership, payments for unrealized receivables and unstated goodwill made to a general partner are considered section 736(a) payments. However, there is some latitude in drafting the partnership agreement to designate goodwill payments as property payments taxable under section 736(b) and, therefore, not IRD. A deceased S corporation shareholder receives his or her pro rata share of any IRD items (accrued but unpaid income items) as IRD. The decedent's S corporation stock, however, receives a basis step-up.
Transferring the rights to IRD
As a general rule, the transfer of a right to receive IRD, whether by gift or by sale, triggers immediate taxation of the IRD to the transferor. However, the general rule is inapplicable to a "transfer to a person pursuant to the right of such person to receive such amount by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent" (section 691(a)(2)). In those cases, the transferee (rather than the transferor) is taxable on the IRD when it is paid to the transferee. This treatment stems from the concept that income earned over years or as a result of the termination of long-term employment should not be bunched into the one tax year of estate administration. Example (1) in Regs. section 1.691(a)-2 showcases this result. Accordingly, the transfer of IRD under section 691(a)(2) creates a tremendous planning opportunity to defer the realization of IRD and to transfer it to a beneficiary in a lower tax bracket. Taxation should be deferred until the beneficiary actually receives the income.
In a basic example concerning retirement accounts, if a child's residuary trust is the designated beneficiary of a decedent's retirement plan, the child has the right to stretch the minimum required distributions from the IRA over his or her life expectancy. Because IRD is taxable income only as it is received, the deferral of income tax on the distributions is achieved through this planning approach. However, estate planners must be careful. If IRD is transferred to an heir or trust in fulfillment of a pecuniary gift (a gift of a fixed dollar amount) as opposed to a fractional gift or a residuary bequest, the transfer is treated as a "sale" of the benefits, causing immediate realization of income to the funding trust (the transferor). This was the case in Letter Ruling 200644020, which concluded that the transfer of a dollar amount of an IRA to satisfy a charitable gift triggered tax to the transferring entity. Using IRD for charitable bequests can be a good strategy, but it's an area that requires attention to detail by an experienced tax adviser to achieve optimal results.
To better understand the result in Letter Ruling 200644020, it is helpful to contrast that ruling with Letter Ruling 200702007. In the latter letter ruling, a decedent who was a participant in a qualified profit sharing plan designated a qualified terminable interest property (QTIP) trust as the beneficiary of his interest in the plan. The designation of the QTIP trust as a beneficiary did not trigger the acceleration of tax on the IRD when the plan passed to the trust. Instead, the amounts of IRD in the plan were included in the gross income of the beneficiary of the QTIP trust only when she received a distribution from the trust. Though not explained in the ruling, the rationale for this treatment appears to be that the account was transferred, intact, to the QTIP by reason of the decedent's estate plan.
Another planning idea for retirement assets that works to eliminate IRD and double taxation is a deathbed Roth conversion. Under this strategy, the decedent pays the embedded income tax liability before death and then passes the Roth IRA to his or her child. Factors that may make a deathbed Roth conversion favorable include (1) a relatively small estate, and therefore little or no section 691(c) deduction, and (2) circumstances where the effective income tax rate of the beneficiary is expected to be equal to or greater than that of the decedent. The risk to this strategy is that subsequent legislation could change the rules governing Roth IRAs.
Rollert Residuary Trust , 80 T.C. 619 (1983), aff'd, 752 F.2d 1128 (6th Cir. 1985), states the general rule that IRD items are not included in distributable net income. In Rollert, an estate claimed an income distribution deduction for the distribution of rights to receive future payments of IRD to the decedent's residuary trust, without having taken the value of the rights into the estate's gross income. The court held that this treatment was inconsistent with section 691 and that the full value of the payments actually received was includible as IRD in the years received by the residuary trust.
In Chief Counsel Advice 200644016, the IRS noted that the assignment of rights to receive IRD to a beneficiary by a trust or estate is governed by different rules than the receipt of actual payments by the trust or estate, followed by a distribution of cash to the beneficiaries. The residuary legatee must report amounts subsequently collected as IRD when collected.
Section 691(b) ensures that the deductions corresponding to the IRD included in taxable income are not lost because of death. Without such a law, deductions could be lost with the death of the taxpayer whose services or activities generated the related IRD. The so-called deductions in respect of a decedent (DRD) encompass five deductions and one credit, including section 162 business expenses, section 163 interest deductions, section 164 deductions for taxes, section 212 expenses for the production of income, section 611 depletion deductions, and the section 27 foreign tax credit (see Regs. section 1.691(b)-1(a)). The deduction cannot be accelerated, but rather is allowable only to the person who receives the IRD to which the deduction relates.
Calculating the section 691(c) deduction
Even if IRD is recognized in taxable income, if the estate was subject to federal estate tax, the Code permits a deduction to prevent the IRD from being taxed both as an asset of the estate and as income to the recipient.
Indeed, Regs. section 1.691(c)-1 sets forth the method of calculating the amount of the deduction and its allocation. In step one of the calculation, one must first add up the fair market value of all IRD items included in the decedent's gross estate, as calculated for federal estate tax purposes. Next, the net value of the IRD is determined by reducing the IRD by the total amount of DRD. Then, the net estate tax on the gross estate is calculated, including the value of all IRD, and that number is reduced by any credits allowed. Finally, the estate tax is calculated with all of the IRD items removed. The simplest way to do this is to remove the IRD items (and related DRD items) in the software program used to prepare the Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, and determine what the estate tax would have been if no IRD had been included in the estate. The difference between the two figures is the net estate tax attributable to the IRD. That is the amount of the section 691(c) deduction.
If one beneficiary received all of the IRD in one tax year, the allocation of the deduction is easy to complete. That taxpayer includes the IRD items on his or her Form 1040 and deducts the full section 691(c) deduction as calculated above. (It is important to note that a section 691(c) deduction is not subject to the 2 percent-of-adjusted-gross-income limit on miscellaneous itemized deductions.) If, however, multiple beneficiaries receive different items of IRD across several, or even decades of, tax years, the calculation becomes more intricate. In that case, the issue arises as to how to treat the investment income attributable to the IRD earned subsequent to the transfer of the account to the beneficiary, but which has yet to be distributed and therefore taxed to the beneficiary. For example, if a beneficiary of her father's IRA elects to take distributions over her life expectancy (commonly called a stretch IRA payout), what portion of the annual minimum required distribution (MRD) is IRD? The IRS has been silent on this issue.
Many advisers use a first-in, first-out approach. Under this methodology, each distribution is deemed to be made first from the IRD in the retirement account until the dollar value of the deduction is exhausted. In this way, the beneficiary is relieved from making an annual determination of the portion of the MRD that is IRD versus subsequently earned investment income. A good way to handle the calculation is to provide a schedule to the beneficiary that shows the MRD for the ensuing years when there will be a corresponding section 691(c) deduction. The schedule continues until the section 691(c) deduction is exhausted. In situations with multiple beneficiaries, the section 691(c) deduction is allocated pro rata. In other words, the amount of the section 691(c) deduction is multiplied by the fraction of the IRD property received by the beneficiary. Using the deduction in a year when no IRD is taxable to the recipient is not permitted.
Although the IRD rules are contained in only one Code section, the concept permeates many aspects of proper tax preparation following a taxpayer's death. The complexity of implementing the rules is exacerbated when there are different preparers for the Form 706 estate tax return and the subsequent Forms 1041, U.S. Income Tax Return for Estates and Trusts, and Forms 1040 for the recipients of IRD and section 691(c) deductions. Strong recordkeeping and the creation of schedules delineating the annual deduction are recommended to keep taxpayers from losing this valuable deduction.
Excerpted from the April 2015 issue of The Tax Adviser. Copyright © 2015 by the American Institute of Certified Public Accountants, Inc.