Income in respect of a decedent (IRD) is untaxed income that a decedent has earned or had a right to receive during his or lifetime. Sources of IRD include, but are not limited to, the following:
- Uncollected salaries, wages, bonuses, vacation pay and sick pay earned before death but paid after death.
- Interest, dividends, rents and royalties that accrued before death but paid after death (including interest on Series EE savings bonds unless decedent reported interest annually or reported interest of final Form 1040).
- Annuity payments after death in excess of the decedent's basis in the contract.
- Distributions for qualified pension plans, SEP, Keogh and IRA accounts (except for Roth IRA distributions).
- Accounts receivable of a deceased sole proprietor.
- Recognized gains on the sale of property sold before death but collected after death.
Since the taxes on the IRD income has not yet been paid, the amount is included in the gross income of ONE OF THE FOLLOWING:
- "The estate of the decedent, if the right to receive the amount is acquired by the decedent's estate from the decedent". 26 U.S.C. §691(a)(1)(A); OR
- "The person who, by reason of the death of the decedent, acquires the right to receive the amount, if the right to receive the amount is not acquired by the decedent's estate from the decedent". 26 U.S.C. §691(a)(1)(B); or
- "The person who acquires from the decedent the right to receive the amount by bequest, devise, or inheritance, if the amount is received after a distribution by the decedent's estate of such right." 26 U.S.C. §691(a)(1)(C).
This can come as a shock to beneficiaries that thought their inheritances would be tax-free, especially if their state does not have an inheritance tax and the decedent was not subject to the federal estate tax. Whether it is the beneficiary or the estate, somebody has to pay the income taxes due. For example, if a decedent leaves a $500,000.00 non-Roth IRA to a beneficiary (and that beneficiary would have to take minimum distributions by age 70 ½), then the beneficiary is paying income taxes on the distributions from the account. Some special rules apply if the IRD is in the hands of a beneficiary, not the estate:
- The amount included in gross income is the fair market value of the IRD property at the time of transfer plus the amount by which any consideration for the transfer exceeds fair market value. 26 U.S.C. §691(a)(2). IRD is explicitly excluded from any "stepped-up basis" permitted by the Internal Revenue Code. 26 U.S.C. §1014(c).
- The character of the income in the hands of the beneficiary is the same as the character of the income would have been in the hands of the decedent. 26 U.S.C. §691(a)(3). For example, if the IRD would have been subject to capital gains tax rates for the decedent, then it is considered capital gains for the beneficiary.
IRD is counted within the gross estate of the decedent and, as such, may be subject to federal estate taxes in addition to federal income taxes. If the gross estate exceeds $11.4 million per individual in 2019, then the IRD will be taxed twice, first at the estate level (up to 40%), then second as income to the beneficiary. These taxes may very well deplete the IRD before it makes it to the hands of the inheritor. Fortunately, the Internal Revenue Code provides a tax deduction under 26 U.S.C. §691(c) for any additional estate tax caused by the IRD asset to avoid the double-taxation effect.
What does this mean in plain-speak? Consider an example where a decedent has a gross estate of $20 million which includes a $2 million IRA bequeathed to his son. Since the total estate is over $11.4 million, it is subject to the federal estate tax (for purposes of this example, assume the maximum tax rate of 40%). For the $2 million IRA, the proportional ratio of the federal estate tax against it is $800,000. The highest individual tax rate in 2019 is 37%. Without the IRD deduction, the total IRA would be subject to both the federal estate tax of $800,000 and the beneficiary's income tax rate of $740,000 for a total of $1,540,000 (a 77% total tax rate!). However, with the IRD deduction, the beneficiary's taxable value of the IRA is reduced by the ratio of the federal estate tax against it ($2,000,000 - $800,000 = 1,200,000 taxable value). The beneficiary's income tax due on the IRA at the maximum 37% is $444,000 for a total of $1,244,000 (reduced to a 62.2% total tax rate). The IRD deduction is significant and will save money. NOTE: While an individual may be subject to the 37% tax rate, the effective tax rate will actually be much lower due to some income being applicable to lower tax rates and the inclusion of other tax deductions and credits.
The actual amount of the IRD deduction is slightly more complicated to calculate due to additional IRS regulations. The decedent's federal estate tax liability is calculated twice - once including all assets in the estate (as would normally be done), and again including everything except before-tax items. 26 C.F.R. §1.691(c)-1(a)(2). The difference in estate tax liabilities is the IRD deduction. Other factors may affect the actual taxes due so it is advisable to do the math with an experienced tax professional.
When the IRD deduction applies, it is claimed as a miscellaneous itemized deduction on the beneficiary's Schedule A, but one that is not subject to the 2%-of-AGI threshold that applies to other miscellaneous itemized deductions (as such, the IRD deduction was not suspended by the Tax Cuts and Jobs Act of 2017). It is also not treated as an adjustment for purposes of calculating alternative minimum tax. However, the IRD deduction does not affect or reduce any estate tax liability to an individual state.
The rules regarding income with respect to a decedent can be confusing and, if ignored, can lead to penalties and interest from the Internal Revenue Service. If you received any money or property as an inheritance, it is always advisable to speak to a tax professional to learn about any tax consequences that may apply to you. If you have further questions about income with respect to a decedent or any other aspect of federal taxation, do not hesitate to contact the attorneys at Kershaw, Vititoe & Jedinak PLC today.