Income in Respect of a Decedent
The concept of Income in Respect of a Decedent (IRD) is an often overlooked tax and financial planning consideration that can impact certain estates, heirs and beneficiaries. The topic of discussing a decedent’s financial affairs is certainly not a pleasant one in many cases, but it is important for executors and the loved ones involved in a decedent’s estate to properly understand this concept. In some cases it can be equally as important to have properly planned an estate in advance to ensure that any negative impact of IRD can be minimized. Proper understanding can allow for proactive planning where possible - as well as compliance with the tax code.
So what is IRD?
IRD is established by Internal Revenue Code (IRC) Section 691 and stipulates rules around any taxable income that a decedent was entitled to, but had not yet recognized for income tax purposes prior to their death. It is effectively the concept that previously untaxed income during a decedent’s life must ultimately face tax at a point following the decedent’s death.
The most common example of IRD is deferred income in the form of a retirement account such as a 401(k) or traditional IRA. This income was deferred from the decedent’s income while they were contributing to the account(s) over the years and those contributions grew tax free. The income tax on these assets will still be due when they are distributed, just as they would’ve been had the decedent taken withdrawals from the accounts during his or her life.
Other common examples of IRD are rents due from properties or receivables from business interests owned by the decedent, unpaid wages (salary, bonus, commissions), dividends and interest from brokerage accounts, NUA, vested but unexercised stock options, and more.
Why is this important?
Taxable income associated with the items above have not yet been recognized for income tax purposes at the time of the decedent’s death. Therefore, they are not included on the decedent’s final individual income tax return, which only recognizes income received during the year up until the taxpayer’s death. Instead, the income is reported (and tax owed) by its ultimate recipient, whether that be an heir, beneficiary, or the estate of the decedent itself. Executors and heirs, as well as their advisors, CPAs, and estate planning attorneys, should understand IRD when advising clients in this situation.
Keep your basis
Any recipient heirs or beneficiaries do not receive a “basis-step” in the asset’s tax basis for IRD items when received through the estate. This is important to note because IRD is unlike most other inherited assets, which may receive this “basis step”. What does this mean in plain English?
Normally, an asset included in a decedent’s taxable estate will have it’s income tax basis stepped up (or down) to what the asset’s fair market value was on the date of the decedent’s death. This is attractive for heirs for several reasons but mainly because it provides flexibility to the heir to be able sell inherited property at little-to-no tax cost. For example, if a decedent owned stock in a taxable brokerage account that was acquired for $10,000, but was worth $50,000 at the time of their death, if the asset were to have a basis step, the heirs would inherit the stock with a new tax basis of $50,000. In this basic example, the heirs could then sell the asset for $50,000 and have $0 capital gain, and therefore $0 of tax liability from the sale. Without this basis-step, the heirs would potentially have to realize $40,000 of gain and pay resulting taxes, thus reducing the overall retained wealth of the inheritance.
For items of IRD however, this is not the case. Since IRD assets are effectively income receivables, they did not have basis to begin with - since they were never taxed. Allowing a step in their basis without anyone (decedent) ever having paid to acquire the assets would permit a step in basis while having entirely avoided income tax. This violates the doctrine that all income is taxable when it is constructively received. Thus, inheriting items of IRD can be less appealing to heirs. This is something families should consider when they are determining equitable division of an estate or drafting a thoughtful estate plan. With proper planning however, the less desirable impacts of IRD can possibly be mitigated.
An Example
Let’s say an unmarried taxpayer passed away while being owed a $50,000 bonus for services performed at work. The decedent also owned a IRA worth $1 million. Both the bonus and IRA are forms of IRD and taxable to their recipients.
If the entire $50,000 bonus is paid to the estate, this would be included as income on the decedent estate’s income tax return for that year in which it was received. The IRA however does not receive the same treatment when inherited by a beneficiary. As the decedent was unmarried, the receiving beneficiary of the IRA would naturally be a nonspouse. Nonspousal IRA beneficiaries may choose to take annual withdrawals from the account over their lifetimes, with only the amount withdrawn each year being included as taxable income. This example displays how both recipients - the estate and the nonspousal beneficiary - are responsible for paying tax when the IRD-related asset is receeived. However, the timing of that receipt may differ depending on the assets and income items involved. Planning for IRD can help to reduce, defer, or spread out the tax ramifications over potentially many years.
Planning Matters
Be thoughtful of heirs when leaving assets that produce IRD.
For those with a diversified base of assets, if retaining overall wealth in the family is a primary goal, it may be wise to have a plan for their estate to be as tax-efficient as possible. For those that may want to make charitable bequests, this is incredibly important.
Given what we now know about assets that can produce IRD, it may be wise to designate taxable assets (i.e. ones that do not produce IRD) that can receive a step-up in tax basis to individual heirs and have items that produce IRD (i.e. an IRA or 401(k)) designated to a charitable beneficiary. In this instance, a charitable beneficiary would receive the IRA and as a tax-exempt entity not incur the same tax that a family member or other individual heir would if they were to receive this asset. Further, an individual beneficiary that would receive a taxable asset would enjoy the step-up in basis that would not be available if they inherited an IRA. Being mindful about which heirs should inherit which assets can lead to real savings in this instance. This is just a simple example of how being thoughtful about the disposition of assets of your estate can maximize overall family tax efficiency and avoid unnecessary taxes.
Understand available ird tax deductions
If the inclusion of any IRD assets in a decedent’s estate caused estate taxes to be due, the IRD beneficiary recipient is eligible for an income tax deduction for the estate taxes paid attributable to that IRD asset. Under current Federal law, estate taxes are a rarity due to currently high tax exemptions (over $11 Million per person in 2019). However, if someone does inherit an IRD asset that was included in a taxable estate, that recipient is entitled to a tax deduction equal to a percentage of the income they receive that was already included in a taxable estate, multiplied by the estate tax rate paid. For example, if a $1 Million IRA was included in a decedent’s estate, and that estate incurred Federal estate tax leading to a 40% tax rate, any income that would be received by the beneficiary would yield a 40% income tax deduction. Failing to recognize this available deduction, and take proper advantage of it, could lead to unnecessary double taxation - once by the estate of the decedent, and then also by the inheriting heir.
At its core, the concept of IRD seems fairly straightforward: If income had been deferred or not yet recognized during a person’s lifetime and was not yet taxed by the time of their death, it is entirely reasonable for the eventual receipt of the income to be taxed to its ultimate recipient. In practice, applying the concept can be anything but straightforward. While the rationale for this tax may be simple, the proper reporting and associated planning opportunities associated with IRD are less obvious. Most CPAs and advisors overlook this planning concept or fail to understand it entirely.
For those who may potentially be subject to estate taxes, IRD can become a much more complex issue with corresponding deductions and the potential for double taxation. In either case, it is often important to involve your professional advisors to ensure proper steps are being taken when faced with IRD. If you have questions about IRD and how to properly account for it in your financial plan, please contact us to learn more.
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