In plain English, IRD is income the decedent earned but did
not receive prior to death.
The inclusion of IRD on both the estate tax return (Form 706)
and the recipient's income tax return creates the potential for double
taxation. Fortunately, to potentially eliminate this result, the tax code provides an income
tax deduction for any estate tax paid that is attributable to IRD.
| | Income in Respect of a Decedent
Taxpayers are generally required to recognize income for
federal income tax purposes in the year in which it is received. If, however,
someone dies before receiving income to which he or she is entitled, that
income is not included on his or her final income tax return. Instead, such
income, referred to as "income in respect of a decedent," or IRD, is included
as gross income in the decedent's estate for federal estate tax purposes. And,
IRD also becomes taxable income to the person or entity who ultimately receives
it (in direct contrast to the general rule that inherited property is not
included in an heir's taxable income).
The inclusion of IRD on both the estate tax return (Form
706) and the recipient's income tax return creates the potential for double
taxation. Fortunately, to potentially eliminate this result, the tax code provides an income
tax deduction for any estate tax paid that is attributable to IRD.
What constitutes IRD?
According to the Internal Revenue Code, IRD represents
"those amounts to which a decedent was entitled to receive as gross income but
which were not properly includable in computing taxable income for the taxable
year ending with the date of his death." In plain English, IRD is income the
decedent earned but did not receive prior to death. Common sources of IRD
include:
- Uncollected salaries, wages, bonuses, commissions,
vacation pay, and sick pay
- Uncollected alimony
- Uncollected rent
- Interest and dividends accrued
- Distributions from certain deferred compensation and stock
option plans
- Taxable distributions from employer-sponsored retirement
plans, including pension plans, profit-sharing plans, and simplified employee
pension plans (SEPs)
- Taxable distributions from individual retirement accounts
(IRAs)
- Gain from the sale of property if the sale is deemed to
occur before death, but proceeds are not collected until after death
- Accounts receivable of a sole proprietor
- Difference between the face amount and the decedent's
basis in an installment sales obligation
- Distributive share of partnership items for the period
before death for a partnership tax year that ends after death, unless the death
causes the partner's tax year to close
Who owes income tax on IRD?
IRD is taxed to the person or entity receiving it. This can
be the decedent's estate, the surviving spouse, or some other beneficiary. IRD
is reported on the recipient's income tax return in the year it's received. If
IRD is paid to the decedent's estate, it is reported on the fiduciary return
(Form 1041). If IRD is paid directly to a beneficiary, it is reported on the
beneficiary's income tax return (Form 1040).
Character of IRD
The character of the income taxed to the recipient is the
same as it would have been in the hands of the decedent; capital gains are
taxed as capital gains, and compensation and interest are taxed as ordinary
income. There is no step-up in basis for IRD items.
Deductions in respect of a decedent
There are also deductions in respect of a decedent (DRD),
which can offset IRD. DRD items are deductible expenses that were owed at the
time of death, but not yet paid. Such items might include real estate taxes,
state income tax, and deductible interest. As with IRD, DRD can be taken on
both the estate tax return and the beneficiary's income tax return, and must be
deducted in the same manner as the decedent would have taken the deduction.
The deduction can be taken by the IRD recipient who is
obligated to and actually pays the DRD items. DRD items are deductible in the
year in which they are paid.
If DRD is taken on the estate tax return, the income tax
deduction for estate tax paid on IRD is limited to net IRD (IRD minus DRD).
Income tax deduction for estate tax paid on IRD
If estate tax is paid on IRD, a deduction can be claimed on
the income tax return that must report the IRD. For individual taxpayers, the
deduction is available (as a miscellaneous deduction) only if they itemize. The
deduction, however, is not subject to the 2% AGI floor for miscellaneous
itemized deductions.
The deduction is calculated by recomputing Form 706 without
IRD, then subtracting this number from the original estate tax due. The
difference is the estate tax on IRD and the amount of the total deduction.
The IRD recipient's portion of the deductible tax must then
be determined by:
- Dividing the value of the IRD included in the
beneficiary's income by the total value of the IRD included in the decedent's
estate (not reduced by DRD), then
- Multiplying this fraction by the total estate tax
deduction
Example:
Amy dies leaving three children, Bob,
Candy, and Dennis. Bob and Candy each inherit $10,000 in IRD items, and Dennis
inherits $5,000 in IRD items. Bob becomes liable for $1,000 in DRD items. The
net IRD included in Amy's estate is $24,000 ($10,000 + $10,000 + $5,000 -
$1,000). Assume the estate tax attributable to the IRD items is $10,800. Each
child's estate tax deduction is calculated as follows: Bob and Candy: $10,000 / by $25,000 = 0.4 0.4 x $10,800 = $4,320 each Dennis: $5,000 / by $25,000 = 0.2 0.2 x $10,800 = $2,160 Planning for IRD
If IRD items will make up a large portion of your estate,
failing to plan for them may have unintended results. For example, say you
leave your house to your son and your IRA (composed of deductible contributions
and earnings) to your daughter. If the house and the IRA have the same market
value, your daughter will end up receiving less than your son because she will
have to pay income taxes on each IRA distribution she receives. You can potentially eliminatesuch results by properly allocating IRD items.
Here are some strategies to consider:
- Leave IRD items to charity, which is exempt from income
taxes.
- Leave an IRA to a young beneficiary, which has the
potential to defer the payment of income taxes for as long as possible.
- Leave IRD items to a credit shelter trust. This postpones
the payment of estate tax until the death of the surviving spouse, and thus the
payment of income taxes.
For further help with planning for IRD, see your estate
planning attorney or tax planning professional.
While trusts offer numerous advantages, they incur up-front costs and often have ongoing administrative fees. The use of trusts involves a complex web of tax rules and regulations. You should consider the counsel of experienced estate planning, legal, and tax professionals before implementing trust strategies. |