Can Estate Reduce IRAs’ Value for Tax Purposes?

gross estate includes the fair market value of all of the decedent’s property. IRAs are part of the gross estate, but beneficiaries of inherited IRAs do not report taxable income until after they receive distributions. The tax code classifies these items as “income in respect of a decedent” (IRD); both the decedent’s estate and the beneficiary must pay tax. However, the beneficiary can deduct the amount of taxes the decedent’s estate pays on the IRD.

On February 16, 2000, when Doris Kahn died, she owned two IRAs with a combined value of $2,620,410. On its tax return the estate reduced the IRAs’ value by the amount of tax the beneficiary would owe when he or she received distributions and valued the IRAs at $2,219,637. That amount, the estate argued, was the IRAs’ fair market value—the amount a willing buyer would pay and a willing seller would accept in an arm’s length transaction—as a buyer would consider future tax liability before determining a price. The IRS disagreed and assessed the estate a deficiency. The estate petitioned the Tax Court for relief.

Result . For the IRS. The estate argued that in prior cases courts considered the property’s fair market value. One court allowed a reduction in the fair market value of stock in a closely held corporation because a buyer would consider the corporation’s built-in tax liability of its appreciated assets before making an offer. Another court permitted a reduction in the fair market value of stock with resale restrictions because buyers would consider the future burden of such restrictions in any offer. A third court said a potential purchaser would consider clean-up costs before buying contaminated land. The estate argued that the court should apply the same logic to IRAs because a buyer would base any offer on the anticipated tax burden.

The Tax Court distinguished these earlier situations from an IRA. In the former the willing buyer/seller test applied directly to the property; in the latter it applied to the assets underlying the IRA. In addition the buyer of such assets does not assume the tax burden; the beneficiary retains responsibility for any future taxes. Further, because the underlying assets are already fully marketable, the potential buyer does not assume additional burdens if he or she decides to sell them.

This case distinguishes the valuation of IRAs from other property interests. The court’s ruling—that a discount should not be allowed when determining the value of an IRA—is similar to Estate of Smith v. United States (300 FSupp2d 474, affd. 391 F3d 612 (5th Cir. 2004)), which held that the estate should not discount the value of the decedent’s retirement account to offset the beneficiary’s future tax liability.

Estate of Doris F. Kahn v. Commissioner, 125 TC no. 11.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.