Proper IRD planning can preserve family wealth.

• Author: Strobel, Caroline D.
• Position: Income in respect of a decedent

Income in respect of a decedent (IRD) crops up in all sizes of estates. However, strategies exist for minimizing or eliminating the double tax IRD items generally bear. This article provides examples and planning strategies for minimizing IRD.

Normally, the income tax basis of inherited property is the value at which it is included in a gross estate; under Sec. 1014(a)(1), this is the date of death (DOD) fair market value (FMV). (1) However, if alternative valuation is validly elected, the property's FMV at the earlier of its date of disposition or six months after the decedent's death controls. (2) For appreciated property, the basis step-up rule allows any appreciation in the property's value that occurred while held by the decedent to completely escape Federal income taxation (even when no estate tax is payable). Thus, elderly individuals approaching death have a powerful incentive to retain appreciated property.

IRD

Unfortunately, not all appreciated property included in an estate receives this favorable basis treatment. Items of income in respect of a decedent (IRD) do not receive a basis step-up and, thus, are potentially subject to both estate and income taxes. Under Regs. Sec. 1.691(a)-1(b), IRD includes:

1. All accrued income of a cash-method decedent (e.g., accrued bond interest, declared but unpaid dividends and accrued rents).

2. For an accrual-method decedent, income accrued solely by reason of the decedent's death (e.g., death benefit or lawsuit claim).

3. Income to which the decedent had a contingent claim at his DOD (e.g., lawsuit claim or commissions on premiums paid after the DOD).

4. Any retirement benefits the decedent owned.

   Many estates include one or more IRD items. Fortunately, proper planning for IRD can mitigate the excessive tax burden that might otherwise apply.

   Definition and Treatment

   According to Regs. Sec. 1.691(a)-1(b), IRD refers to gross income items to which a decedent was entitled at death, but were not properly includible in taxable income for the year of death (or prior years) under his accounting method. There need be no legally enforceable right to receive the IRD item, but the payment must clearly represent a right of receipt that arose prior to death (e.g., uncollected salary of a cash-basis taxpayer and/or the income or gain on an installment sale).

   Like all assets owned by a decedent at death, IRD is fully includible in the gross estate; basis of an IRD item carries over from the decedent. Consequently, any inherent appreciation at death triggers taxable income on collection, subsequent sale or other disposition. Sec. 691(a)(3) provides that an IRD item has the same character in the transferee's hands as it had in the decedent's.

   Under Sec. 691(c)(1)(A), a recipient who includes IRD in gross income can take an itemized deduction for estate tax paid by the decedent's estate on the item, thus providing limited relief from double taxation. (3) The deduction is not subject to the Sec. 68 2%-of-adjusted-gross-income (AGI) limit, but the itemized deduction phaseout rules apply. (4) An IRD recipient may deduct a pro-rata portion of the total Federal estate tax paid attributable to the inclusion of IRD items (net of related expenses and deductions in respect of a decedent (DRD)) in the decedent's estate. According to Sec. 691(c)(2) and (3), this incremental amount is the excess of the Federal estate tax actually incurred over that calculated by excluding IRD items (less DRD and related expenses) from the estate tax computation. (5)

   Example 1: H, a cash-basis taxpayer, sold land under an installment contract in 2001 that he had held as an investment for 10 years. He did not elect out of the installment method. H's basis was $50,000; the sales price was $360,000. Under the buyer's note, H is scheduled to receive eight annual payments of $45,000 each (plus 10% interest) beginning in 2003. H died in 2002, when the note's FMV was $360,000. His gross estate must include the note's FMV. If P, H's daughter and sole heir, receives the note from H's estate in 2002, she will report each installment payment received. H's gross profit percentage (GPP) for installment-sale purposes is gross profit/selling price; this is ($360,000 - $50,000)/$360,000 or 86.11%. Beginning in 2003, P will report $38,750 ($45,000 x 86.11%) of long-term capital gain (plus accrued interest received) on receipt of each installment payment. She will also be entitled to deduct (as an itemized deduction) a portion of the estate tax paid by H's estate attributable to the inclusion of the installment note's income element. (6) (In 2003, the IRD will be both the capital gain portion of the installment receivable, as well as the interest that accrued until H's death.)

   Types

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