When an inheritance is too good to be true – How income in respect of a decedent works
Most people are genuinely appreciative of inheritances, and who wouldn’t enjoy some unexpected money? But in some cases, it may be too good to be true. While most inherited property is tax-free to the recipient, this isn’t always the case with property that’s considered income in respect of a decedent (IRD). If you have large balances in an IRA or other retirement account — or inherit such assets — IRD can be a significant estate planning issue.
IRD is income that the deceased was entitled to, but hadn’t yet received, at the time of his or her death. It’s included in the deceased’s estate for estate tax purposes, but not reported on his or her final income tax return, which includes only income received before death.
To ensure that this income doesn’t escape taxation, the tax code provides for it to be taxed when it’s distributed to the deceased’s beneficiaries. Also, IRD retains the character it would have had in the deceased’s hands. For example, if the income would have been long-term capital gain to the deceased, such as uncollected payments on an installment note, it’s taxed as such to the beneficiary.
IRD can come from various sources, including unpaid salary, fees, commissions or bonuses, and distributions from traditional IRAs and employer-provided retirement plans. In addition, IRD results from deferred compensation benefits and accrued but unpaid interest, dividends and rent.
The lethal combination of estate and income taxes (and, in some cases, generation-skipping transfer tax) can quickly shrink an inheritance down to a fraction of its original value.
What recipients can do
If you inherit IRD property, you may be able to minimize the tax impact by taking advantage of the IRD income tax deduction. This frequently overlooked write-off allows you to offset a portion of your IRD with any estate taxes paid by the deceased’s estate and attributable to IRD assets. You can deduct this amount on Schedule A of your federal income tax return as a miscellaneous itemized deduction. But unlike other deductions in that category, the IRD deduction isn’t subject to the 2%-of-adjusted-gross-income floor.
Keep in mind that the IRD deduction reduces, but doesn’t eliminate, IRD. And if the value of the deceased’s estate isn’t subject to estate tax — because it falls within the estate tax exemption amount ($5.45 million for 2016), for example — there’s no deduction at all.
Calculating the deduction can be complex, especially when there are multiple IRD assets and beneficiaries. Basically, the estate tax attributable to a particular asset is determined by calculating the difference between the tax actually paid by the deceased’s estate and the tax it would have paid had that asset’s net value been excluded.
If you receive IRD over a period of years — IRA distributions, for example — the deduction must be spread over the same period. Also, the amount includible in your income is net IRD, which means you should subtract any deductions in respect of a decedent (DRD). DRD includes IRD-related expenses you incur — such as interest, investment advisory fees or broker commissions — that the deceased could have deducted had he or she paid them. Thus, to minimize IRD, it’s important to keep thorough records of any related expenses.
As you can see, IRD assets can result in an unpleasant tax surprise. Because these assets are treated differently from other assets for estate planning purposes, contact your estate planning advisor. Together you can identify IRD assets and determine their tax implications.