Strategies for minimizing the impact of income in respect of a decedent.

• Author: Young, Audrey G.

Advisers focused on private clients commonly overlook planning for the income and estate taxes on income in respect of a decedent (IRD).This item discusses issues created by IRD and presents strategies and planning insights to assist taxpayers and their tax advisers with minimizing its impact.

IRD includes items of income earned or accrued during life but not received until after death. According to the Sec. 691 regulations and commentary over the years, IRD has four characteristics:

1. The item of income would have been taxable to the decedent if the decedent had survived to receive the income;

2. The income right had not matured sufficiently to have been properly included in the decedents final income tax return;

3. The receipt must be of income and not a capital asset described in Sec. 1014(a); and

4. If the item of IRD is payable to someone other than the decedent's estate, the taxpayer acceding to it must have acquired the property right solely because of the decedent's death.

The most frequently received items of IRD are compensation income, commissions, retirement income, certain partnership distributions, and payments for crops. Under Sec. 691(a), IRD must be included in gross income by the estate or other person who acquires the right to receive the income for the tax year when received.

Even though a decedent does not receive IRD before his or her date of death, the property is still included in the decedent's estate because it is considered property in which the decedent had an interest at death, within the meaning of Sec. 2033. IRD does not receive a step-up in basis since the income has not been taxed on the decedent's income tax return. As such, IRD creates both estate and income tax liabilities. Sec. 691(c) offers some mitigation of the double taxation by allowing the IRD's ultimate recipient to reduce the amount of taxes owed through an income tax deduction for estate tax paid with respect to the IRD. This item reviews the Sec. 691(c) calculation and methodology.

IRD represents income to the person (or entity, in the case of the decedent's estate) who receives the income. For example, deferred compensation payments often are taxed to the decedent's surviving spouse, partnership receipts are frequently taxed to the decedent's estate, and retirement income is principally taxed to the decedent's surviving spouse or designated beneficiary.

Beneficiaries of a cash-basis decedent must claim all IRD when actually received unless the income was constructively received on the decedent's date of death. By contrast, beneficiaries of an accrual-basis decedent must claim as IRD only qualified death benefits and deferred compensation owed to the decedent. The other components of income, such as interest and wages accrued on the decedent's date of death, would be reported on the final Form 1040, U.S. Individual Income Tax Return, of the accrual-basis decedent.

The examples in the regulations, as well as the case law interpreting Sec. 691, provide the context for interpreting Sec. 691 and determining the amount of IRD, the character of the IRD, the identity of the taxpayer required to report the IRD, and the proper tax year for reporting the IRD. The first example in the Sec. 691 regulations concerns a decedent entitled upon his death "to a large salary payment to be made in equal annual installments over five years" (Regs. Sec. 1.691(a)-2(b), Example (1)). In the hypothetical, the estate collects two installments, and the right to the remaining installments is distributed to the residuary legacy of the estate. In this case...