Income in respect of a decedent: minimizing the double taxation.

• Author: Streer, Paul J.

Generally, Sec. 1014(a) provides that property acquired from a decedent has a basis equal to its fair market value (FMV) on the date of the decedent's death. Consequently, on the subsequent disposition of such property, neither the estate nor the beneficiary will pay income tax on appreciation existing at death. However, a notable exception exists under Sec. 1014(c) for property that constitutes a right to receive an item of income in respect of a decedent (IRD). According to Regs. Sec. 1.691(a)-1, such property consists of income items that the decedent was entitled to receive at death, but which were not properly includible in his taxable income for the tax year ending with the date of death or a prior tax year under his method of accounting. Although IRD items are fully includible in the decedent's gross estate, they receive no basis adjustment; instead, the decedent's basis carries over to the IRD recipient, who must pay income tax when the income is recognized. Limited relief from double taxation is provided under Sec. 691(c), which allows the recipient to deduct the estate tax paid attributable to the inclusion of the IRD in the decedent's estate. This deduction is available only if there is a taxable estate, and only if the IRD bears tax.

Proper tax planning is necessary to minimize the double taxation of IRD items in an estate. No single strategy can be employed to deal with the tax impact of IRD effectively. One strategy might be to ensure that the IRD will be taxed to a lower-bracket beneficiary. This can be accomplished either by having the IRD item pass directly to such beneficiary or by having the estate make a distribution of IRD in the year of receipt to one or more beneficiaries. This action is particularly important in view of the compression of the estate and trust income tax rates by the Revenue Reconciliation Act of 1993 (RRA). Under See. 1(e), the 36% tax bracket now applies to taxable income in the $5,501 to $7,500 range; all income in excess of $7,500 is taxed at a marginal rate of 39.6%. Another strategy might be to defer income recognition over a period of years.

This article discusses the types of income that frequently qualify as IRD items and the various provisions that affect their taxation; covers deductions in respect of a decedent (DRD) and the deduction for estate taxes paid on IRD; explains the pitfalls and offers planning ideas to deal with various types of IRD; and analyzes techniques to minimize IRD taxation (e.g., the funding of both charitable and other bequests with IRD items and the selection of a tax year).

Scope of IRD

The concept of IRD stems from Congress's desire to ensure that all income accrued by a cash-basis decedent prior to death ultimately bears income tax. Further, under Sec. 691(a)(3), IRD also incorporates the notion that the character of income as taxed to the recipient should be the same as if the decedent had lived to receive it. The dimensions of IRD are broader and more elusive than the Code and regulations seem to imply.

The courts have frequently been called on to establish the parameters of IRD. For example, in Est. of Peterson,[1] the Tax Court used several requirements to determine whether post-death sales proceeds were IRD: whether (1) the decedent entered into a legally significant arrangement, such as a contract, prior to death; (2) the decedent performed substantive nonministerial acts required as preconditions to the sale; (3) any economically material contingencies might disrupt the sale; and (4) the decedent would have eventually received the sales proceeds had he lived.

Example 1: A contract of sale is entered into to sell a shopping center. The contract requires the correction of several small municipal violations. At the seller's death, most, but not all, of the violations have been corrected. After the decedent's death, the sales price of the contract is renegotiated to allow for the additional corrective work. The sales proceeds are not IRD.

Had all work been completed to meet municipal inspection standards so that only the closing remained after death, the sales proceeds would have been IRD.

Whether a sales transaction has proceeded sufficiently far for the proceeds to be IRD is often difficult to determine. Each case must be individually examined to determine whether the Tax Court criteria have been met.

Under Sec. 691[a)(1) and Regs. Sec. 1.691(a)-1, a receivable is IRD if (1) the item would have been taxable to the decedent had he lived to receive it, (2) the item was not properly includible in the decedent's final return, (3) the item represents a passive right to receive income (as opposed to a property right) and (4) the right to receive the income was obtained by the recipient solely as a result of the death of the creator of the right.

Categories of IRD

Most IRD can be divided into four distinct categories: compensation, investment income, sales and partnership investments.

* Compensation for services

The unpaid salaries, wages, bonuses and commissions of a cash-basis decedent who was an employee are all IRD items.[2] Deceased employees' entitlement to payments for unpaid vacation and sick pay are similarly treated.[3] These items usually pass directly to a surviving spouse or other family member; generally, the amount is not large and provides little tax effect.

Example 2: G died on Mar. 20, 1995. At that time, G's employer owed him a month's wages, two weeks of vacation pay and a month's sick pay. B, G's wife, receives G's remuneration and includes it on their 1995 joint return. The income tax effect will be as if G had worked for an additional 2 1/2 months during the calendar year. The remuneration will also qualify as property passing to B and included in computing the estate tax marital deduction.

Deferred compensation arrangements can also produce IRD. As shown in Regs. Sec. 1.691(a)-2(b), Example 1, if the employee dies while some of the postponed payments remain unpaid, the unpaid amounts are IRD items. Regs. Sec. 1.421-8(c)(4)(iii) provides that if an incentive stock option (ISO) is not exercised by the decedent's estate or beneficiary, it is property that constitutes a right to receive IRD. Under Sec. 421(c)(1), if the estate or beneficiary exercises the ISO, no income is recognized on receipt of the stock, but is recognized on disposition of the stock. If an employee dies holding unexercised nonqualified stock options, this difference is IRD in all cases.

IRD includes any account balances in the decedent's qualified pension and profit-sharing plans and individual retirement arrangements (IRAS),[4] as well as a lump-sum distribution from a decedent's IRA that consists of both deductible and nondeductible contributions. However, the decedent's nondeductible contributions are excluded from the total.[5] For corporate executives with generous retirement benefits, it is not unusual for these retirement-related IRD items to be the principal assets in their gross estates.

The right to receive compensation does not have to be fixed at the time of death. A mere expectancy or substantial likelihood of receiving a payment is sufficient to cause the item to be included as IRD.[6]

Similar rules apply to the compensation-related income of self-employed cash-basis individuals. Typical IRD items include fees earned by a cash-basis professional prior to death[7] and insurance renewal commissions.[8] Keogh plan balances may also be significant IRD items.

A surviving spouse should normally be the beneficiary of retirement plan funds, because the funds can then be rolled over into the survivor's IRA.[9] Thus, payments from a retirement plan can be spread over a number of years and perhaps be taxed at lower rates than if the estate, or another family member, were the pension plan beneficiary.

When salary, bonuses and other items of compensation are paid to family members or to the estate, Sec. 101(b) provides a possible death benefit exclusion. The first $5,000 received that is not a gift from the decedent's employer is eligible for the exclusion. When multiple beneficiaries receive payments, the $5,000 must be allocated among them in proportion...