Allocation of IRD deduction to surviving spouse with no estate tax liability.

Background

Income in respect of a decedent (IRD) is subject to both the estate tax of the decedent and income tax when received by the beneficiary. Relief is provided for this potential double tax under Sec. 691(c). An IRD recipient is allowed a deduction, for income tax purposes, of the Federal estate tax attributable to the inclusion in the decedent's estate of the right to receive the income. This deduction must be claimed as an itemized deduction, but is not subject to the 2% floor for miscellaneous itemized deductions. The amount of the deduction is calculated as follows: (1) Determine which items included in the gross estate represent items of gross income in respect of the decedent. Subtract from the total of the IRD items the deductions from the gross estate for claims that represent the deductions and credits in respect of the decedent. (2) Compute the portion of the estate tax attributable to inclusion in the gross estate of the net value determined above. This is the excess of the estate tax as filed over the estate tax computed without including the net IRD value in the gross estate. Under Regs. Sec. 1.691(c)-1(a)(2), the recalculation of the tax must consider all items affected by the elimination of the net IRD; i.e., the marital deduction must be reduced by the amount of IRD items received by the surviving spouse. Each IRD recipient is allocated a portion of the reduction in the estate tax based on the percentage of gross IRD received. If the amount actually received is less than the amount of IRD reported on the estate tax return, the lower amount is used to determine the allocation. The deduction is not necessarily allocated equitably. The beneficiary who receives the income is entitled to the Sec. 691(c) deduction even if she was not allocated any portion of the estate tax. For example, the estate tax may be paid out of the residue of the estate, while the IRD may be specifically bequeathed to a beneficiary who does not share in the residue. None of the estate tax will be paid by the heir receiving the IRD, but all of the IRD deduction will be allocated to her.

Interaction of the marital and IRD deductions

The Sec. 691(c) deduction will be allocated inequitably when the surviving spouse and other heirs receive IRD. When the estate is entitled to the maximum marital deduction and no estate tax is due, there will not be an IRD deduction. On the other hand, if the maximum marital deduction is not used and an estate tax is paid, the surviving spouse may be allocated part of the estate tax deduction although there was no tax liability allocated to her portion of the estate (due to the marital deduction).

Example: Husband, H, died, survived by his wife, W, and son, S. H had an annuity, valued at $100,000. S and W receive 50% each of the annuity. The annuity is the only item of IRD in the estate. There are no deductions in respect of decedent. H left 50% of his estate (after all deductions except the marital deduction) to S; W received the balance of the estate and her portion qualified for the marital deduction. The value of the gross estate is $2,500,000. The marital deduction is $1,250,000, and is the only deduction. The taxable estate is $1,250,000, resulting in an estate tax of $207,100. To recalculate the estate tax for the Sec. 691(c) deduction, the $100,000 annuity is subtracted from the taxable estate of $1,250,000 and the portion of the marital deduction attributable to the annuity ($50,000) is added back, resulting in a taxable estate of $1,200,000. The result is a Federal estate tax of $189,800. The estate tax attributable to the IRD is $17,300 ($207,100 -- $189,800). The annuity is fully taxable and completely distributed during the current year. W and S will each report an $8,650 Sec. 691(c) deduction as a miscellaneous itemized deduction, not subject to the 2% limitation, on Schedule A of their Forms 1040. W is allocated part of the deduction, even though her portion of the annuity is sheltered from estate tax by the marital deduction. S, who paid all of the estate tax out of his bequest, received the benefit of only 50% of the IRD deduction.

Conclusion

For most marital deduction plans, it makes no difference whether the IRD is allocated to the marital deduction bequest. However, if a plan calls for a less than optimal marital deduction, consideration should be given as to where the IRD items are allocated and who will receive the benefit of the deduction for income tax purposes.