Abstract: Generally, inherited property isn’t included in an heir’s taxable income. But some assets consist of income in respect of a decedent (IRD), and if a family member receives an IRD asset, he or she will be subject to income tax on it. This article discusses what IRD is and ways to reduce its impact on beneficiaries.
Income in Respect of a Decedent (IRD)
A thorn on the wealth transfer rose
You bequeath a substantial portion of your estate to your niece, Helen. You think to yourself, “Helen will be so pleased. She could really use the income.” But Helen may not think so highly of you when it comes time to pay her income tax.
Generally, inherited property isn’t included in your heirs’ taxable income. But some assets consist of income in respect of a decedent (IRD), and, if your heirs receive an IRD asset, they will be subject to income tax on it. Let’s take a closer look at IRD and what you may do to reduce its impact so your beneficiaries don’t receive an unwelcome gift when you die.
Recognize your IRD assets
In a nutshell, IRD is income a decedent earned and was entitled to receive but never actually received before his or her death. A typical IRD asset is the decedent’s last paycheck for wages not paid until after death. Because the decedent’s tax year closes on his or her death date, these funds aren’t included in the decedent’s income on his or her final tax return. As an item of IRD, the paycheck is included in the decedent’s estate for estate tax purposes and is taxed as income to whoever receives it.
IRAs and other qualified retirement plans are other common examples of property subject to IRD when received by a beneficiary. Additional types of IRD include the decedent’s:
o Unpaid bonuses,
o Deferred compensation benefits,
o Uncollected proceeds of a sale made before death,
o Accrued but unpaid interest, dividends and rent,
o Unpaid fees and commissions, and
o Uncollected payments on an installment note.
IRD retains the same character in the recipient’s hands as it would have had in the decedent’s hands had he or she lived to receive it. Items that would have been ordinary income to a decedent are ordinary income to the estate or other recipient.
Avoid surprises
Unlike most assets included in an estate that receive a step-up in basis — such as stock with a low income tax basis or a personal residence — IRD assets don’t receive a new basis at death. So they are subject to both income and estate tax. This double tax burden can surprise beneficiaries who were unaware that they owed income tax on these assets.
If IRD assets make up an increasingly larger share of estates, failure to plan for them can result in an unintended outcome. For example, assume you leave your house to your son and your IRA to your daughter. Even if both assets have the same market value at your death, your daughter may end up receiving much less because she must pay income tax on the value of the asset she receives.
Your son’s income tax basis in the house he inherited is adjusted upward to the house’s fair market value on your death date. If he sells the house immediately, he may not owe any capital gains tax. But your daughter will have to pay income tax on each distribution she receives from her inherited IRA. The income tax she will owe effectively reduces the total amount she inherited.
When planning for IRD assets, be certain your beneficiaries can defer the income tax payment as long as possible. If you want to give a specific amount of cash to a beneficiary, be sure your estate has enough non-IRD assets to fund the gift. If IRD assets have to be used to satisfy the bequest, your estate will owe income tax on the amount of IRD distributed.
Consider the potential deduction
Although a recipient must include IRD in his or her income, an income tax miscellaneous deduction is available based on the estate tax attributable to the net value of the income item. For example, assume you inherit a $2 million IRA from your parent who has a total estate worth $4 million. If your parent dies in 2004, his or her estate is calculated based on all taxable assets, including IRD assets such as the IRA. The federal estate tax due is approximately $1,185,000. Next, the federal estate tax, excluding the IRA, is calculated, which reduces the estate taxes due to $225,000.
The $960,000 difference between the two amounts represents the maximum IRD income tax deduction that you can take against the IRA distributions your parent gave you. Because IRA payments typically are spread over a period of years, such as your life expectancy, the maximum deduction also is spread over the same period. Each year you’ll deduct a portion of the IRA distribution with a portion of the IRD deduction. As you might expect, this process requires detailed record keeping.
For individual taxpayers, the deduction is available only if they itemize but isn’t subject to the 2% adjusted gross income floor for miscellaneous deductions. Taxpayers in the upper tax brackets could lose out on some of the benefits of the deduction because of the 3% phaseout of itemized deductions. Of course, no estate tax means no income tax deduction.
Expand your focus
When planning your estate, expand your focus beyond estate tax reduction by considering the effects of IRD. By properly allocating assets that will be treated as IRD, you can minimize the impact of the double taxation on your beneficiaries.
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