Tax planning opportunities for U.S. Series E and EE savings bonds.

Many taxpayers own U.S. Series E and EE savings bonds. These bonds, issued at a discount, can be redeemed for fixed amounts that increase at stated intervals. The difference between the purchase price and the amount received at redemption is interest income, when the bonds are redeemed. Under Sec. 454(a), taxpayers can elect an accrual basis for Series E and EE savings bonds. Taxpayers can elect to recognize the annual increase in the bond's redemption value as interest income as it accrues, rather than reporting all of the income in the year in which they redeem the bond. Two situations exist in which taxpayers should consider electing to recognize the annual increase as interest income.

Accrual-Basis Election

The first situation involves untaxed accrued interest on Series E and EE savings bonds owned by a deceased taxpayer. A generation of taxpayers born prior to World War II invested heavily in savings bonds as patriotic investments. As this generation passes, situations in which a tax election on these bonds can benefit these taxpayers' estates increase. At first glance, it appears that the untaxed accrued interest would be income to the estate on a fiduciary income tax return (Form 1041, U.S. Income Tax Return for Estates and Trusts) when the estate redeems the bonds. However, under Rev. Rul. 68-145, the personal representative (or such other responsible party) can elect (under Sec. 454(a)) to report the untaxed accrued interest when a decedent dies as interest income on the decedent's final individual income tax return. The personal representative must elect this treatment. Once made, the election is not revocable without IRS consent. If the estate continues to hold the bonds, it should recognize the annual increase in their value as accrued interest income on Form 1041. This treatment should continue until the estate redeems the bonds or they are transferred to a beneficiary. If the bonds were transferred, the beneficiary would not be bound by any election made by the estate and could elect a cash or accrual basis for the bonds.

If the personal representative elects to include the untaxed accrued interest on the decedent's final individual return, the estate could save considerable taxes, as individual tax brackets are significantly larger than the estate and trust tax brackets. In addition, even if the decedent lived for only a portion of the year, the decedent's personal exemption and standard deduction (if applicable) would not be prorated. The estate taxes would also be reduced because the payment of the income taxes on the final individual return reduces the estate's value for estate tax purposes. For example, if a decedent has $20,000 of untaxed accrued interest on Series E and EE bonds and no other taxable income at death, the total income tax and estate tax savings from including the untaxed accrued interest on the final return would be approximately $5,504 (see Exhibit 1). The income tax savings would be reduced if the decedent had other taxable income at death.

The second situation involves untaxed accrued interest on bonds owned by a child. If a child owns these bonds and does not elect to recognize the annual increase as accrued interest income, a significant tax liability could occur when the bonds are redeemed. If the child is under 14 when the bonds are redeemed, the bond interest could be taxed at the parents' top marginal income tax rate. If an election is made to recognize the accrued increase annually, no income taxes would be paid on the accrued interest on Series E and EE savings bonds if the child's unearned taxable income in any year does not exceed the annual threshold ($750 for 2002). For example, if a child under 14 has $5,000 of accrued interest when the bonds mature and the parents' marginal income tax rate is 39.1%, the tax savings on recognizing the annual accrued interest would be approximately $1,481 (see Exhibit 2) (assuming the annual accrued interest recognized does not exceed the child's annual threshold).

If the parents elect the accrual method for the annual increase, the child should file an individual return in the same year, attaching a statement electing the accrual method. Even if the child's income is below the filing threshold, the child should file the return to activate the election. The child does not need to file an individual return in future years, as long as income remains below the filing threshold.

Revoking an Election

A taxpayer can revoke an election to accrue interest on U.S. savings bonds only with IRS consent. To obtain automatic IRS consent, taxpayers should file a statement with their return for the change year; see Rev. Proc. 99-49. The statement must be identified at the top as "Change in Method of Accounting under Section 6.01 of the Appendix of Revenue Procedure 99-49."

Conclusion

Many sources exist to determine the current redemption value for U.S. savings bonds. Tables are available from the U.S. Government Printing Office. The information is also available on the U.S. Public Debt Internet site, at www.publicdebt.ustreas.gov. In the year of election, reportable interest income is the difference between the total redemption value for bonds owned on the last day of a tax period and their purchase price. In subsequent years, reportable interest income is the difference between the redemption value on the last day of the current tax period and the redemption value on the last day of the previous tax period.

By not overlooking elections or making the correct election, significant tax savings can result and value added to a tax adviser's services. The two situations discussed highlight opportunities to reduce income taxes for individual taxpayers and estates.

Exhibit 1: Decedent's Tax Savings

Assumptions:
Filing status: single
Age: 65 or older
Tax year: 2001
Untaxed accrued interest on Series E and EE savings bonds at
time of death: $20,000
Other taxable income at time of death: $ 0

                             Untaxed accrued
                             interest included     Untaxed accrued
                               on decedents       interest included
                               final return      on fiduciary return

Untaxed accrued interest         $20,000              $20,000
Standard deduction              ($ 5,650)                   0
Personal exemption               ($ 2,900)             ($ 600)
Taxable income                   $11,450              $19,400
U.S. income tax liability        $ 1,721              $ 6,588
Overall tax savings              $ 4,867

Estate tax savings are based on minimum estate tax rate after
considering the unified credit:
$1,721 x 37% = $637.
Total income tax and estate tax savings from including untaxed accrued
interest on decedent's final individual income tax return:
$4,867 + $637 = $5,504.
Exhibit 2: Child's Tax Savings

Assumptions:
Filing status: single
Age: under 14
Tax year: 2001
Untaxed accrued interest on Series E and EE savings bonds when bonds
mature: $5,000
Parents' marginal income tax rate: 39.1%
Accrued interest recognized annually does not exceed the child's annual
threshold ($750 for 2001)

                                   Accrued interest
                                  recognized annually
                                  on individual return (1)

Untaxed accrued interest                 $ 500
Standard deduction                      ($ 750)
Personal exemption                           0
Taxable income                          ($ 250)
U.S. income tax liability (2)                0
Overall tax savings                     $1,481

                                   Accrued interest
                                  recognized when the
                                   bonds mature on
                                   individual return

Untaxed accrued interest                $5,000
Standard deduction                      ($ 750)
Personal exemption                           0
Taxable income                          $4,250
U.S. income tax liability (2)           $1,481
Overall tax savings

(1) This example assumes that the total interest of $5,000 is earned
on a 10-year Series E or EE bond and an equal amount of interest
would be recognized annually on the individual return.

(2) First $750 taxed at child's individual income tax rate of 15%.

FROM PHILLIP J. KORB, MBA, MS TAXATION, CPA, AND THOMAS E. VERMEER, PH.D., CPA, UNIVERSITY OF BALTIMORE, BALTIMORE, MD (NEITHER AFFILIATED WITH BAKER TILLY INTERNATIONAL)