SBJPA change to IRD items for decedents holding S stock.

The Small Business Job Protection Act of 1996 (SBJPA) included several significant legislative changes to the tax provisions affecting S corporations. Included in these changes is the addition f Sec. 1367(b)(4)(A) and (B). This section provides that any person acquiring stock in an S corporation by reason of the death of a decedent or by bequest, devise or inheritance shall apply Sec. 691 to any item of income of the S corporation in the same manner as if the decedent had held directly his pro rata share of such item. In other words, such person must treat as income in respect of a decedent (IRD) the pro rata share of any item of income of the corporation that would have been IRD if the income had been acquired directly from the decedent. What this section means and what effect this modification will have can best be analyzed by first understanding IRD, the IRD tax provisions as they apply to partnerships, and how the new legislation applies to S stock.

What Is IRD?

IRD is, generally, income earned before the decedent died but received after his death. For a cash-basis taxpayer, this means the taxpayer was entitled to the income during his life but did not live to constructively or actually receive it. For example, IRD may include unrealized receivables, installment sales entered into prior to death payable after death, deferred compensation received after death, or the decedent's final paycheck received after his death. Sec. 691 and the regulations thereunder provide that (1) the decedent's estate or other successor to the decedent must include IRD in income when received; (2) the character of the IRD is determined as if the decedent had actually received the IRD; and (3) under Sec. 691 (c), the successor to the decedent is entitled to an income tax deduction for the estate tax attributable to the IRD in the same year the IRD is includible in income by the successor.

IRD and the Partnership Provisions

On an individual basis, the estate or other successor generally takes a basis in the decedent's property equal to the asset's fair market value (FMV) at the time of death. Normally, this process eliminates from income taxation the unrealized appreciation in an asset's value. However, this step-up in basis applies only to the unrealized appreciation of assets owned by the decedent at death. It does not apply to income earned or realized but not yet reported by the decedent at the time of death. For example, assume a cash-basis individual taxpayer sells an appreciated asset on jan. 1, 1996, then dies before the installment note has been collected in full. Under the rules just described, the decedent had earned or realized the appreciation of the asset but had not yet reported the full amount of the sales proceeds. The estate or other successor is prohibited from obtaining a stepped-up basis in the installment note, since the underlying asset was not owned by the decedent at the time of death. In this way, the estate may not recognize less income on the note than the decedent would have recognized if the note had been collected in full prior to the date of death.

For partnerships, the Code and regulations provide two categories of items attributable to a partnership interest that constitute IRD: First, payments (as described in Sec. 736(a)) to an heir or the estate in partial or complete liquidation of the decedent's partnership interest and payments that the decedent was receiving at the time of death due to his retirement and that continue to the deceased partner's successor. Second, IRD includes the distributive share of partnership income attributable to the period ending with the date of the partner's death (Regs. Sec. 1.753-1(b)).

Example 1: A and B are members of the ABC partnership. Both A and B have calendar year-ends. B's distributive share of partnership income is $300,000, which is earned ratably during the year. B died on June 30, 1996. Given these facts, the estate would include the entire $300,000 of B's distributive share for 1996 as income, of which 6/12, or $150,000, would be IRD for purposes of computing the Sec. 691 (c) deduction.

In addition to these rules, a major aspect of the IRD rules as they apply to partnership interests can be found in Sec. 1014. According to Sec. 1014(a), the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, in general, be the FMV of the property at the date of the decedent's death.

Example 2: Assume the same facts as in Example 1. Further, the value of B's partnership interest at the time of death is $1,000,000. Under Sec. 1014(a), the basis of the partnership interest in the hands of the person acquiring the decedent's interest will be "stepped-up" to the property's FMV at the time of death, or $1,000,000. However, when the inherited property includes items constituting IRD (such as the $150,000 of partnership income under Regs. Sec. 1.753-1 (b)), Sec. 1014(c) prohibits the basis step-up. Thus, the new basis of the partnership interest in the hands of the person acquiring the interest from the decedent will be $850,000 ($1,000,000 FMV -- $150,000 IRD).

How Does This Affect S Stock?

Regs. Sec. 1.742-1 provides that the new basis of a partnership interest acquired from a decedent is reduced to the extent its value is attributable to items constituting IRD. Even though S income is taxed to its shareholders in a manner similar to the taxation of a partnership and its partners, prior to the adoption of the SBJPA, there were no comparable rules requiring a reduction in the new basis of the stock in an S corporation acquired from a decedent when the S corporation held IRD items. This created a loophole that allowed for some unintended tax planning. As an example, while an individual who sold an asset on the installment basis would create IRD for the gain inherent in the principal amount remaining on an installment note at death, this IRD could have been avoided by first transferring the asset to a wholly owned S corporation and selling it out of the corporation on the installment method followed by a liquidation of the corporation after death. It was thus possible for such income when recognized to escape income taxation; see Letter Ruling 9622012.

The SBJPA committee report provides that a person acquiring stock in an S corporation from a decedent would treat as IRD his pro rata share of any item of income of the corporation that would have been IRD if that item had been acquired directly from the decedent. The stepped-up basis in the stock of an S corporation acquired from a decedent is. reduced by the portion of the stock's value attributable to IRD items. With the addition of Sec. 1367(b)(4)(A) and (B), the treatment of IRD items with respect to stepping up the basis of inherited S stock has dissolved the tax advantages previously available.

For decedents dying after Aug. 20, 1996, Sec. 1367(b)(4)(B) reduces the potential step-up in basis by the value of the stock attributable to items constituting IRD, as does Regs. Sec. 1.742-1 with respect to partnerships. This new legislation attempts to place those taxpayers with S stock or a partnership interest on a level playing field, while placing tax planners in a position to plan for IRD and the death of an S shareholder under a different light.

From Jay M. Sattler, CPA, Blum, Shapiro & Company, P.C., Hartford, Conn.