Where to Herd Your IRD
Is Income in Respect of a Decedent a Ticking Time Bomb for Future Estates?
by Robert L. Moshman
he estate tax is the sine qua non of estate planning. Estate planning books and seminars focus primarily on the estate tax. By comparison, income in respect of a decedent (IRD) may seem like the most arcane, irrelevant, and dull subject to inhabit the tax code. Well, things may be about to change.
In about one year's time, the estate tax exemption will reach $1.5 million. With basic planning, a husband and wife can avoid all estate tax on a marital estate of $3 million. By 2009, a $3.5-million exemption will mean marital estates of $7 million will be looking beyond the estate tax, and that is likely to be true even if a total repeal is not "permanent."
The departure of estate tax concerns will leave a void. The next tax obstacles to turn our attention will involve the income tax. IRD is one sleeper of an issue that is on a collision course with the scheduled changes in the transfer tax system.
With so many retirement plan opportunities and such attractive rollover options, many estates now have the lion's share of their wealth committed to tax-deferred retirement assets. Such assets are a well-known source of IRD. And without an estate tax, there will be no estate tax deduction from the tax to be paid on income in respect of a decedent, making IRD a larger problem in the near future than it may presently appear to be.
Let's take this opportunity to review where IRD originates and how it can be strategically managed to reduce tax consequences.
Have You Heard of IRD?
To fully grasp IRD, just follow the money. The stream of income that an individual has set in motion during life continues to flow even after that individual has died. Some of the income that flows after death will have been accrued by the decedent during his or her lifetime. Since individuals operate on a cash basis, they don't pay income tax on accrued compensation that has not yet been paid. Such accrued earnings that arrive after death are considered income in respect of a decedent and are subject to tax rules and consequences described by Internal Revenue Code (IRC) §691.
The simplest example of IRD is a paycheck that arrives after death. These funds were earned by the decedent's lifetime efforts-they just arrived after the fact. Another classic example is the commission an insurance agent is entitled to when a client renews a policy. Consider several other common sources of IRD:
Distributions from qualified retirement plans and IRAs are IRD. Note, however, that Roth IRAs, containing assets that have already been taxed, would not produce any IRD;
Deferred compensation and bonuses;
Declared dividends that have not been paid;
Accrued income on partnership interests or S corporation stock;
Savings bond income where an election is made to pay tax upon distribution rather than as income accrues;
Undeclared income from an installment obligation;
Actors, artists, authors, and inventors with copyrights, patents or other intellectual properties, are also likely to have royalty income constituting IRD at the time of death.
The Cartwright Estate
As the majority shareholder, chairman, and chief rainmaker of his law firm, Robert Cartwright was paid a salary of $18,000 per month at the time of his death. However, the majority of his compensation was paid in the form of an annual end-of-year bonus that was based on his contribution to the firm. To acquire Mr. Cartwright's 71% of outstanding stock, the law firm purchased $5 million of life insurance, which was paid to Mr. Cartwright's estate after his death in 1988.
What was intended to be a standard buyout, serving the dual purposes of enabling the firm to redeem the shares and continue while the estate was assured of having converted stock into liquidity, was tripped up by one phrase. By explicitly denoting the $5 million as payment for stock "together with any claim to cases and work in process," the shareholder's agreement was evidence that a portion of the insurance proceeds should be treated as compensation.
In fact, the IRS found that about $4 million of the payment was compensation and was therefore taxable as income. And since this income arrived after Mr. Cartwright's death, it was "income in respect of a decedent" (IRD).
Although it is a rare estate that encounters enough IRD to be blindsided with an additional $1.1 million of income tax liability as occurred in, Estate of Cartwright v. Comm'r. (CA-9, 1999), IRD is not uncommon. In fact, it is ubiquitous. It occurs so often, with such divergent assets and beneficiaries, that it generates an extraordinary array of tax outcomes. So while there are many effective IRD management strategies, selecting the right one can be challenging.
Avoiding IRD
One approach is to avoid the creation of IRD in the first place. While many items of IRD may be unavoidable, they can at least be identified and incorporated into a plan. It then becomes important to be aware of newly created or unintended IRD that may arise, especially if sizable amounts are involved.
Example #1: A contract for the sale of an interest in property may result in IRD if the contract is consummated after death. Thus, where Farmer had a contract to sell a 256-acre farm to Ford Motor Company for $4,000 per acre before his death (making way for a heavy duty truck assembly plant in the vicinity of
Louisville) his estate's right to specific performance (under Kentucky law) made it possible for the deal to be concluded after Farmer's death. As a result, the sale proceeds constituted IRD. Claiborne v. United States, 648 F.2d 448 (6th Cir. 1981).
Example #2: A businessman entered a contract to sell a hotel chain for $3.53 million. Cash and stock were placed in escrow pending the resolution of contingencies. The deal closed shortly after the businessman died. The sale proceeds were treated as IRD for which no stepped-up basis applied, so a gain of $3.45 million was realized. As an alternative approach, the contract can include provisions that finalize the sale only after the seller's death, or which enable the executor to rescind and renegotiate the contract after the seller's death. This approach not only avoids IRD but also enables the property held by the estate at death to qualify for a stepped-up basis.
IRD Strategies
As shown below, many IRD strategies have been designed to take advantage of the various tax characteristics that apply. One of the more broadly applicable strategies arises from the fact that IRD is taxed at the recipient's tax rate. As a result, all of the traditional income-shifting techniques come into play-
Accelerating IRD if the decedent or the estate is in a lower income tax bracket than beneficiaries or legatees. Note that the estate's effective tax bracket may be reduced if the income tax deduction for estate tax paid as a result of IRD in the estate;
Distributing IRD to the beneficiary with the lowest tax bracket;
Authorizing the executor to distribute IRD prior to receipt;
Providing the executor with the discretionary authority to "spray" IRD to several beneficiaries or multiple trusts so that they all remain in lower tax brackets;
Transferring IRD rights from the estate to legatees before they become collectible (i.e., taxable).
How much can this approach save? If $100,000 of IRD that would ordinarily result in $38,600 of income tax at the 38.6% rate in the estate were instead distributed to three legatees in such a manner as to be entirely within the 27% income tax bracket, $11,600 of tax savings can be gained.
Does this technique work on a larger scale? Yes, in theory. Working with round numbers, $1 million of IRD is taxed at an effective rate of 38.6% and faces a tax of $386,000 in the decedent's estate. The same $1 million would face a lighter tax burden with an effective tax rate of 27% and a tax of $270,000. However, saving $116,000 takes some work. Accomplishing this in a single tax year will involve the division of the $1 million among 15 or 20 beneficiaries. Theoretically, one could try to move IRD into the 15% tax bracket and save a large amount. But in light of where brackets change, accomplishing this in a single tax year would involve distribution of IRD to about 35 beneficiaries (who each lack other income). This strategy is therefore highly theoretical.
Moving larger amounts of IRD to numerous beneficiaries in a single year can involve significant planning and administration, not to mention the potential for guardianships or trusts for minors. Larger amounts of IRD can be distributed over multiple years.
Caution: Note that several important exceptions apply to the taxation of IRD. In many states, IRD is treated as principal for fiduciary accounting purposes. This means that IRD that is used to fund a trust is taxed to the trust rather than the trust beneficiaries-a result reminiscent of trapping distributions involving distributable net income or the treatment of income from partnerships, S corporations and limited liability companies. Distribution of the right to IRD in satisfaction of a pecuniary legacy (i.e., a specific dollar amount) will also cause the income taxation of the asset to be accelerated and payable by the estate under §691(a)(2).
Strategic IRD Opportunities
There are several important IRD characteristics, each of which creates strategic opportunities.
Fiscal Year: IRD is taxed when it becomes collectible, and therefore may arrive in time to be included in the fiscal year covered by the decedent's final income tax return, or subsequently as part of the estate's income tax return.
Strategy — Timing: Where possible, IRD can be accelerated or delayed. Where several payments of IRD to an estate are anticipated,
the estate's fiscal year can be selected to avoid bunching payments and incurring a higher tax bracket.
Selection of Recipient: IRD is taxed to the recipient, at the recipient's tax rate. Thus, IRD paid to an estate is taxed at the estate's income tax rate, while IRD paid to a legatee is taxed at the legatee's tax rate. Note that in, Letter Ruling 200230018, the IRS allowed the estate to fund a testamentary charitable gift annuity with a decedent's IRA. As a result, the estate did not have to include the IRA proceeds as IRD. See also, Letter Ruling 199901023, in which the transfer of IRD to a charitable remainder unitrust affected how the estate tax deduction from IRD is calculated.
Strategy — Tax Brackets: Selecting IRD recipients with the lowest tax bracket can reduce the overall income tax impact.
Retained Tax Status: Under §691(a)(3), IRD retains its character, regardless of where it goes. IRD that would have been capital gains, exempt income, earned income, or interest, will still be treated as such in the hands of the recipient.
Strategy — Matching IRD To Beneficiaries: IRD with a particular character can be directed wherever it will do the most good. For example, for capital gains IRD, it may be useful to fund a charitable gift that is not subject to capital gains. Passive income IRD can go to a recipient who has passive losses.
When Taxable: The right to IRD must be distinguished from IRD itself. The right to IRD is not taxable per se. IRD is taxable when it becomes collectible.
Strategy — Transfer Rights to IRD: An estate possessing only the right to IRD may therefore transfer that right to a legatee or other beneficiary who would then pay tax (preferably at a lower tax rate) when such funds are collectible.
Estate Tax Deduction: IRD may be susceptible to double taxation-income tax and estate tax. However, this undesirable outcome is mitigated by an income tax deduction under §691(c) for any estate tax attributable to the IRD.
Strategy — §691(c) Deduction: If an estate is not large enough to trigger an estate tax, IRD can be transferred out of the estate without fear of losing the §691(c) deduction against income tax. If the estate is taxable, retaining IRD may be advantageous.
Note that a soon-to-be released Letter Ruling concerns an issue of first impression concerning the division of a retirement account between a spouse and a non-spouse beneficiary. The spousal portion can be rolled over while the nonspousal portion will result in IRD. The IRS appears to be considering a formula approach for apportioning the estate tax deduction.
Note also that the section 691(c) deduction applies when calculating the alternative minimum tax.
No Stepped-Up Basis: Additional IRD consequences arise because it does not qualify for a stepped-up basis under §1014(c).
Strategy — Charitable Transfers: Since IRD will not benefit from a stepped-up basis in the hands of an individual beneficiary, the use of IRD for charitable gifts (which are not subject to capital gains tax) makes sense. At the same time, funding charitable bequests or trusts with assets that would otherwise qualify for a stepped-up basis would amount to a lost opportunity as well.
Estate Tax Deduction
The estate's exposure to estate tax is also an important consideration in deciding where to direct IRD assets. If an estate is subject to estate tax, a §691(c) deduction is available offset income tax consequences. If the right to IRD is transferred to a beneficiary, the beneficiary will pay income tax when the IRD becomes collectible. That tax will be at the beneficiary's tax rate. The deduction for estate tax attributed to the IRD is taken by the beneficiary as an itemized deduction.
The strategic use of IRD with spousal transfers is directly affected by the overall taxability of the estate. If the estate is taxable, IRD assets can generate an estate tax deduction to the extent that estate tax is attributable to such assets.
If the IRD assets are instead used to fund marital transfers that qualify for the unlimited estate tax marital deduction, they will not generate any tax and therefore, no deduction. Yet, if the estate is not taxable, then it won't matter for estate tax purposes if IRD is used to fund a marital transfer. In fact, with that concern out of the way, it may make sense to transfer IRD to a spouse insofar as the IRD is less likely to appreciate rapidly. However, for some estates, it may be preferable to avoid building up the estate of the surviving spouse.
Retirement Assets: Allocation of the estate tax deduction to spouses is also pertinent in the context of retirement plan distributions. A surviving spouse can elect to treat the entire inherited interest as his or her own IRA.
The Formula Approach: There have been indications that the IRS National Office has been moving toward a rule that simply uses the amount of IRD received by a beneficiary as the numerator and the amount of IRD determined on the date of death (or the alternate valuation date) as the denominator. That fraction would then be used to multiply the amount of estate tax attributable to the IRD.
Final Thoughts
With so many IRD strategies to choose from, the right approach is not a foregone conclusion based on the type of IRD assets involved, the taxability of the estate, or the availability of other assets to fund gifts. On the contrary, IRD strategies should be based on the totality of the estate after balancing a client's overall tax and non-tax objectives and weighing the risks of each alternative.
© K.S. 2002
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