EXECUTIVE
SUMMARY |
CPAs MUST EXERCISE CAUTION
TO CAPTURE CORRECT income in
respect of the decedent (IRD) deductions
on clients’ returns. Since clients
typically don’t understand the issue well
enough to volunteer the existence of IRD,
CPAs must make sure they ask clients the
right questions to elicit the information
they need to prepare a return.
ONE OF THE CRITICAL
TAX-COMPLIANCE ISSUES CPAs
help their clients with is the
proper reporting of IRD—income a
decedent is entitled to at the time of
his or her death but which is not
properly includible on any federal
income tax return. It also includes
income triggered by reason of death,
including IRA distributions.
WHILE IRD IS TAXABLE TO A
BENEFICIARY WHEN he or she
receives it, the law permits the
beneficiary to deduct any estate taxes
attributable to the income. This
itemized deduction is not subject to the
2% of adjusted gross income limitation.
Beneficiaries who do not itemize get no
deduction.
THE COURTS DISAGREE AS TO
HOW TO HANDLE certain types
of IRD. This is particularly true for
income to which the deceased had no
enforceable right, such as a
discretionary bonus paid following
death. CPAs should be aware different
circuit courts of appeal have had
different approaches as well.
IRD RETAINS THE CHARACTER
IT WOULD HAVE HAD in the
decedent’s hands—for example, income
that would have been long-term capital
gain to the decedent is taxed as such to
the recipient. CPAs can calculate the
estate tax attributable to IRD using the
“net value” concept. In the case of
multiple beneficiaries, each recipient
can deduct his or her proportionate
share of the tax. |
RAYMOND A. ZIMMERMANN,
PhD, is associate professor of accounting
at the University of Texas at El Paso. His
e-mail address is
rzimmer@utep.edu . PAT EASON, PhD,
is associate professor of accounting at
the University of Texas. Her e-mail
address is peason@utep.edu
. ANNE LEAHEY is assistant professor
of accounting at the same university. Her
e-mail address is aleahey@utep.edu
. |
Wall Street Journal report
addressed the value of income in respect of the
decedent (IRD) as an income tax deduction. The
report said the combined effects of practitioners’
not realizing a client’s income item constituted
IRD and not knowing how to handle the deduction
made the treatment of IRD on tax returns “probably
the most prevalent error today with respect to
estate taxes.” This article briefly reviews the
concept of income in respect of the decedent,
explains IRD application issues resulting from the
integration of the federal estate tax and income
tax systems and suggests ways CPAs can avoid
missing the IRD deduction.
THE IMPORTANCE OF ACCURACY
Many CPA firms maintain tax practices that
address compliance issues. According to a national
survey by the Texas Society of CPAs, tax services
were the source of 48% to 52% of all fees. One
primary area of practitioner concern relates to
obtaining the information necessary to properly
prepare a client’s tax return. To help eliminate
possible mistakes and omissions, CPAs need to use
special diligence in gathering information.
Once thought to be relatively obscure, IRD
deductions are becoming more common. Big-ticket
IRD items such as distributions from IRAs,
401(k)s, 403(b)s and other tax-sheltered
retirement plans of affluent baby boomers have
been growing in past decades and will be worth
millions when owners bequeath them to estate
beneficiaries. Distributions from these plans
constitute gross income to the beneficiary and
could be subject to marginal federal income tax
rates as high as 35%. Plan balances also are
subject to estate tax rates as high as 48%—a
double whammy. Together, these taxes can severely
reduce the size of a beneficiary’s inheritance.
Proper handling of IRD tax issues,
therefore, is critical to sheltering retirement
plan accumulations from tax. Current federal tax
provisions allow an IRD deduction on the
beneficiary’s income tax return for federal estate
taxes attributable to IRD taxed on the deceased’s
federal estate tax return.
BALANCING DIFFERENT TAX SYSTEMS
The term IRD refers to
income a decedent is entitled to at the
time of his or her death but which is not
properly includible as gross income in any
federal income tax return. This generally
involves a cash-basis taxpayer who had
earned the right to receive income but had
not done so at the time of his or her
death. Common types of IRD include accrued
interest on U.S. savings bonds, savings
accounts and CDs; declared dividends;
lottery winnings paid over a period of
time; and unpaid salary and commissions.
Unlike the above income, which is taxable
whether or not the taxpayer is alive or
dead, IRD also can arise solely because of
the taxpayer’s death, such as with
distributions from 401(k) and 403(b)
accounts, which under most circumstances
become taxable only at death. |
IRD
Exceptions
Certain
“specified terrorist
victims” may be exempt
from the rules
concerning income in
respect of the
decedent. CPAs should
consult Publication
3920, Tax Relief
for Victims of
Terrorist Attacks,
and Publication
559, Survivors,
Executors, and
Administrators,
for additional
information.
Source:
www.irs.gov .
| | |
To eliminate what was perceived to be unfair
and burdensome treatment of IRD in the past (see
“Historical Development of IRD”), Congress changed
the law to make IRD taxable to the beneficiary
when actually received. This prevented the
“bunching” of income and wherewithal-to-pay
issues. However, troubling effects from the
interaction of the income and estate tax
provisions still exist. A decedent’s estate that
exceeds the allowable estate tax and gift tax
exemption equivalent will have IRD taxed twice.
The amount will be subject to tax as an asset (a
receivable) of the estate. Upon distribution the
beneficiary also will be required to recognize IRD
on his or her income tax return. Together, these
two provisions can potentially slash estate assets
by up to 66%. To alleviate the impact of
such double taxation, Congress added IRC section
691(c). Under this mandate a beneficiary who is
required to include IRD as part of his or her
income tax will be allowed an itemized deduction
for estate taxes paid and attributable to the
amount. Not subject to the 2% of adjusted gross
income limitation, the deduction partially
alleviates the impact of IRD in cases where the
beneficiary itemizes. However, beneficiaries who
use the standard deduction get no benefit.
APPLICATION ISSUES FOR
PRACTITIONERS
Probably the biggest difficulty CPAs
face is determining exactly what
constitutes IRD. The regulations under
section 691 say income in respect of
the decedent generally refers to
amounts a decedent was entitled to as
gross income but that were not properly
includible in computing his or her taxable
income for the year ending with the date
of death or for a previous taxable year
under the method of accounting the
decedent employed. IRD includes
All accrued income of a
decedent who reported his or her income
using the cash receipts and
disbursements method of accounting.
Income accrued solely by
reason of the decedent’s death in the
case of a decedent who reported his or
her income using the accrual method of
accounting.
Income the decedent had a
contingent claim to at the time of his
or her death. IRD also includes
all items of gross income in respect of
a prior decedent provided both
The most recent decedent
acquired the right to receive the amount
because of a prior decedent’s death.
The amount was not properly
includible in computing the recent
decedent’s taxable income for the
taxable year ending with the date of his
or her death or for a previous taxable
year. |
|
PRACTICAL
TIPS TO
REMEMBER
|
You
should always ask
tax clients about
assets they have
inherited so you can
properly reflect the
potential income tax
consequences.
Carefully review the
provisions of IRC
section 691 to gain
a clear
understanding of
what the term
income in
respect of the
decedent
(IRD) means. It
can help ensure you
properly reflect it
on a client’s income
tax return and help
him or her gain the
full benefit of the
deduction.
Review
relevant court cases
carefully and take
into account the
fact that each
circuit court of
appeals may treat
key issues
differently.
You can
use the “net value”
concept to calculate
the amount of estate
tax attributable to
IRD. The difference
between the actual
estate tax and an
as-if tax computed
without including
the net value of the
IRD property in the
gross estate is the
estate tax
attributable to that
property.
To make
sure you don’t omit
any IRD deductions
from a client’s tax
return, you should
modify your return
preparation
questionnaire to
include questions
about this issue and
request a copy of
the relevant form
706.
| | |
Treasury regulations give an example of a widow
who acquired by bequest from her husband the right
to receive renewal insurance commissions on
policies her husband had sold while he was alive.
Under the terms of the insurance company
agreement, the renewal commissions were payable
over a period of years. Section 691 did not come
into effect at this point since there was no
estate tax due at the time of the husband’s death;
the marital deduction eliminated any tax
liability. The widow died before all the
commissions were paid and left them to her son.
The example indicates the commissions the widow
had received on her husband’s behalf were IRD and
includible in her gross income in the period of
receipt (while she was alive). However, any
commissions or renewal fees the son later receives
are not includible in the widow’s gross income.
Instead, they are includible in the son’s gross
income in the period he receives them. IRD
in the form of unpaid earned income, accrued
income and payments from tax-sheltered retirement
plans of a cash-basis decedent is easy for CPAs to
identify because it represents fixed or
contractual obligations in place at the time of
the taxpayer’s death. However, a more complicated
type of IRD occurs where the decedent’s right to
receive the item is less certain. For example,
payments a decedent’s surviving spouse receives
outside any employer’s contractual obligations to
the decedent, such as discretionary bonuses
declared at the end of the year in which he or she
died, have produced conflicting court decisions.
In
Estate of O’Daniel, the Second
Circuit Court of Appeals decision did not
turn on whether the decedent had an
enforceable right. Rather, the Second
Circuit looked at the nature and origin of
the payment. As long as it was
compensation for the decedent’s economic
activity on behalf of the employer, the
payment was IRD. In opposing viewpoints
the Fifth Circuit Court of Appeals in
Trust Co. of Georgia v.
Ross and the Sixth Circuit in
Keck both held the decedent’s enforceable
right was crucial in classifying such a
payment as IRD. The question remains
unsettled at the U.S. Supreme Court level.
In a private letter ruling, the IRS
addressed a situation where a trust was
the beneficiary. A taxpayer willed his
IRAs to two different trusts. After his
death his wife claimed her elective
share of his estate under state law. The
IRS, basing its decision on Kincaid
v. Commissioner,
determined the IRA distributions
were IRD. Since the decedent’s estate
was subject to estate tax, the
distributions to the wife, her estate
(which received distributions after her
death) and its beneficiaries were
entitled to a section 691(c) deduction
for the estate tax attributable to the
inclusion of the items in the husband’s
gross estate. |
Historical
Development of IRD
P rior to 1934
IRD items escaped federal income
taxation. They were viewed as
part of the gross estate subject
to estate tax, not as income to
the estate or its beneficiaries.
This treatment allowed large
amounts of income to go untaxed.
In 1934 Congress put a stop to
this by requiring all income
accrued to a decedent at death
to be reported as income on the
decedent’s final income tax
return. This resulted in the
income’s being taxed even though
the deceased had not yet
received it. In essence the
provisions treated cash-basis
taxpayers as accrual-basis
taxpayers and clearly ignored a
basic tenet of taxation: the
wherewithal-to-pay concept.
A fundamental principle of
taxation, this concept rests
on the belief that one should
be taxed on a transaction when
he or she has the means to pay
the tax. Under the 1934
provisions, a decedent’s death
accelerated IRD income
recognition from the period it
originally was scheduled to be
received to the period of the
decedent’s final return. Given
that actual receipt of the
income might have been
scheduled to occur several
years later, it often became
difficult for taxpayers to pay
tax on the accelerated income.
Accelerating all income
recognition to the decedent’s
final tax return resulted in a
“bunching” of income in a
single period. The result?
Both the accelerated income
and all other taxable income
on the decedent’s final return
potentially became subject to
higher tax rates in the
progressive income tax system.
| |
REPORTING IRD
In keeping with the spirit of
fair and equitable treatment of IRD included as
gross income, Congress has allowed IRD to retain
the character it would have had in the decedent’s
hands. Income the decedent would have reported as
ordinary income is classified as such in the
recipient’s hands. Income that would have been
long-term capital gain to the decedent is
long-term capital gain to the recipient.
Additionally, IRD-related deductions and credits
the law would have allowed to the decedent had he
or she lived and paid the same expense (but that
were not properly allowed in any of the decedent’s
tax years) are allowed to the recipient when paid.
Combined with the itemized deduction for estate
taxes attributable to IRD, these provisions
eliminate much of the technical difficulty
associated with such income under prior law.
IRD ESTATE TAX DEDUCTIONS
As noted above the law allows a
beneficiary to deduct an amount equal to any
estate tax attributable to IRD as an itemized
deduction in the year the recipient includes the
IRD on his or her income tax return. Where a
decedent dies owning an IRA, it is possible the
beneficiaries may receive IRA distributions for
many years. As a result practitioners should be
careful to make an accurate calculation of the
estate tax attributable to IRD and the associated
itemized deduction. CPAs can calculate
estate tax attributable to IRD using the concept
of “net value” of IRD items included in the
decedent’s gross estate. This amount is the gross
value of IRD items net of allowable IRD-related
deductions and credits. Estate tax attributable to
IRD then is the excess of the actual estate tax
over an “as-if” estate tax computed without
including the net value of IRD in the gross
estate. Where multiple IRD items are involved, the
deduction is allocated among them.
Example 1. Tom died in
2004 leaving his estate as beneficiary of his IRA.
At the time of his death, the IRA was valued at
$1,500,000; his taxable estate was $4,750,000
(including the IRA). The estate tax is $2,100,800
before the unified credit. The as-if estate tax
excluding the IRA is $1,380,800, also before the
unified credit. The difference between these two
tax liabilities ($720,000) represents the estate
tax attributable to IRD. The recipient of the IRA
distributions can take this amount as an itemized
deduction on his or her tax return. The
deduction on any income tax return is prorated
based on the distribution for that year. If a
beneficiary receives $150,000 this year, he or she
should be allowed a corresponding deduction of
$72,000 ($720,000 3 $150,000/$1,500,000). If the
taxpayer is in the 35% bracket, an income tax
savings of $25,200 results. Assuming this
situation continues, the total tax savings are
approximately $252,000 (or 16.8% of the value of
the IRA).
ALLOCATING IRD AMONG MULTIPLE
BENEFICIARIES
Where multiple IRD items and
multiple beneficiaries are involved, the amount of
estate tax a recipient can deduct is calculated
according to the ratio of the recipient’s share of
gross IRD reported as income to the total gross
value of IRD items.
Exhibit 1
|
|
Example 2. Mary died
leaving $15,000 in gross IRD as part of her estate
consisting of earned but unpaid salary of $7,500,
accrued CD interest of $3,000 and accrued passive
rental income of $4,500. Additionally, Mary owed
$1,500 in property taxes on the rental property.
In accordance with her will, Mary’s son received
the accrued rental property income and associated
expenses ($4,500 and $1,500, respectively). Her
husband and a trust shared the remainder of the
estate equally. The net value of IRD is $13,500
after subtracting the real estate tax liability
from the gross value of IRD items. The estate tax,
after including $13,500 of net IRD and adjusting
for the unlimited marital deduction, is $784,760
at year 2004 estate tax rates. The as-if estate
tax is $780,800. The excess of $784,760 over
$780,800—$3,960—represents the estate tax
attributable to IRD. Given that the
example involves different IRD items transferred
to multiple beneficiaries, each item will retain
the same character it would have held for the
decedent. Also, the recipient can deduct any
IRD-related expenses in the period he or she
actually paid them. Exhibit 1 shows the
allocation of the IRD estate tax deduction among
beneficiaries.
AN EASILY AVOIDED MISTAKE
Once they understand the nuances,
CPAs will not find the allocation calculation
difficult. The real problem lies in the fact that
tax practitioners might overlook the deductibility
of IRD-related estate tax on a beneficiary’s
income tax return. If the CPA was the decedent’s
long-term adviser and continues in that capacity
for the beneficiaries, the return will take the
IRD deduction issues into account. However, if the
IRD recipient uses a different accountant, he or
she could potentially overlook the deduction.
Unless the CPA specifically asks about the
circumstances of the distribution, he or she is
unlikely to handle it correctly. Preparers often
simply see a distribution from an inherited IRA,
report it and calculate the income tax
liability—failing to take into account any
associated IRD deductions. To prevent this problem
CPAs can use a questionnaire like the one
described in exhibit 2 to collect
information about IRD-related distributions.
Exhibit
2
|
| | |
The amount of the omitted deduction could be
substantial for larger estates. Failure to take an
IRD-related estate tax deduction could easily
result in client claims that the CPA is
responsible for financial losses due to the
omission. If caught in time, an amended return may
solve the problem. However, the statute of
limitations for claiming refunds is the later of
three years from the filing date of the return or
two years from the date the tax was paid. The
error may not be caught during this time frame.
CPAs must take care to ascertain whether any
of a taxpayer’s income is derived from such
sources. Since the taxpayer probably is not
knowledgeable about IRD-related issues, it is
necessary for accountants to obtain appropriate
information by including a series of questions on
the return preparation questionnaire. Exhibit
2 lists inquiries CPAs might find useful in
discovering whether or not IRD exists. For clients
who receive inheritances, any Form 706, United
States Estate and Generation-Skipping Transfer
Tax Return, that has been filed often
provides important information. Otherwise, careful
inquiries are essential.
BE AWARE
While the IRD deduction is not an
issue for most clients, the frequency of its
occurrence is increasing. Failure to recognize and
take the allowed IRD deduction could result in
large errors-and-omissions problems for not only
the client but also the preparer. Practitioners
can avoid this pitfall by being aware of the IRD
issues involved and making sure their client
information questionnaire is effective in raising
red flags for IRD-related situations. |