The importance of IRD: greater diligence can help CPAs avoid costly tax return omissions.

EXECUTIVE SUMMARY

* CPAs MUST EXERCISE CAUTION TO CAPTURE CORRECT income in respect of the decedent (IRD) deductions on clients' returns. Since clients typically don't understand the issue well enough to volunteer the existence of IRD, CPAs must make sure they ask clients the right questions to elicit the information they need to prepare a return.

* ONE OF THE CRITICAL TAX-COMPLIANCE ISSUES CPAs help their clients with is the proper reporting of IRD--income a decedent is entitled to at the time of his or her death but which is not properly includible on any federal income tax re turn. It also includes income triggered by reason of death, including IRA distributions.

* WHILE IRD IS TAXABLE TO A BENEFICIARY WHEN he or she receives it, the law permits the beneficiary to deduct any estate taxes attributable to the income. This itemized deduction is not subject to the 2% of adjusted gross income limitation. Beneficiaries who do not itemize get no deduction.

* THE COURTS DISAGREE AS TO HOW TO HANDLE certain types of IRD. This is particularly true for income to which the deceased had no enforceable right, such as a discretionary bonus paid following death. CPAs should be aware different circuit courts of appeal have had different approaches as well.

* IRD RETAINS THE CHARACTER IT WOULD HAVE HAD in the decedent's hands--for example, income that would have been Long-term capital gain to the decedent is taxed as such to the recipient. CPAs can calculate the estate tax attributable to IRD using the "net value" concept. In the case of multiple beneficiaries, each recipient can deduct his or her proportionate share of the tax.

A Wall Street Journal report addressed the value of income in respect of the decedent (IRD) as an income tax deduction. The report said the combined effects of practitioners' not realizing a client's income item constituted IRD and not knowing how to handle the deduction made the treatment of IRD on tax returns "probably the most prevalent error today with respect to estate taxes." This article briefly reviews the concept of income in respect of the decedent, explains IRD application issues resulting from the integration of the federal estate tax and income tax systems and suggests ways CPAs can avoid missing the IRD deduction.

THE IMPORTANCE OF ACCURACY

Many CPA firms maintain tax practices that address compliance issues. According to a national survey by the Texas Society of CPAs, tax services were the source of 48% to 52% of all lees. One primary area of practitioner concern relates to obtaining the information necessary to properly prepare a client's tax return. To help eliminate possible mistakes and omissions, CPAs need to use special diligence in gathering information.

Once thought to be relatively obscure, IRD deductions are becoming more common. Big-ticket IRD items such as distributions from IRAs, 401(k)s, 403(b)s and other tax-sheltered retirement plans of affluent baby boomers have been growing in past decades and will be worth millions when owners bequeath them to estate beneficiaries. Distributions from these plans constitute gross income to the beneficiary and could be subject to marginal federal in come tax rates as high as 35%. Plan balances also are subject to estate tax rates as high as 48%--a double whammy. Together, these taxes can severely reduce the size of a beneficiary's inheritance.

Proper handling of IRD tax issues, therefore, is critical to sheltering retirement plan accumulations from tax. Current federal tax provisions allow an IRD deduction on the beneficiary's income tax return for federal estate taxes attributable to IRD taxed on the deceased's federal estate tax return.

BALANCING DIFFERENT TAX SYSTEMS

The term IRD refers to income a decedent is entitled to at the time of his or her death but which is not properly includible as gross income in any federal income tax return. This generally involves a cash-basis taxpayer who had earned the right to receive income but had not done so at the time of his or her death. Common types of IRD include accrued interest on U.S. savings bonds, savings accounts and CDs; declared dividends; lottery winnings paid over a period of time; and unpaid salary and commissions. Unlike the above income, which is taxable whether or not the taxpayer is alive or dead, IRD also can arise solely because of the taxpayer's death, such as with distributions from 401 (k) and 403(b) accounts, which under most circumstances become taxable only at death.

To eliminate what was perceived to be unfair and burdensome treatment of IRD in the past (see "Historical Development of IRD," page 81), Congress changed the law to make IRD taxable to the beneficiary when actually received. This prevented the "bunching" of income and wherewithal-to-pay issues. However, troubling effects from the interaction of the income and estate tax provisions still exist. A decedent's estate that exceeds the allowable estate tax and gift tax exemption equivalent will have IRD taxed twice. The amount will be subject to tax as an asset (a receivable) of the estate. Upon distribution the beneficiary also will be required to recognize IRD on his or her income tax return. Together, these taro provisions can potentially slash estate assets by up to 66%.

To alleviate the impact of such double taxation, Congress added IRC section 691 (c). Under this mandate a beneficiary who is required to include IRD as part of his of her income tax will be allowed an itemized deduction for estate taxes paid and attributable to the amount. Not subject to the 2% of adjusted gross income limitation, the deduction partially alleviates the impact of IRD in cases where the beneficiary itemizes. However, beneficiaries who use the standard deduction get no benefit.

APPLICATION ISSUES FOR PRACTITIONERS

Probably the biggest difficulty CPAs face is determining exactly what constitutes IRD. The regulations under section 691 say income in respect of the decedent generally refers to amounts a decedent was entitled to as gross income but that were not properly includible in computing his of her taxable income for the year ending with the date of death or for a previous taxable year under the method of accounting the decedent employed. IRD includes

* All accrued income of a decedent who reported his or her income using the cash receipts and disbursements method of accounting.

* Income accrued solely by reason of the decedent's death in the case of a decedent who reported his of her income using the accrual method of accounting.

* Income the decedent had a contingent claim to at the time of his or her death.

IRD also includes all items of gross income in respect of a prior decedent provided both

* The most recent decedent acquired the right to receive the amount because of a prior decedent's death.

* The amount was not properly includible in computing the recent decedent's taxable income for the taxable year ending with the date of his or her death or for a previous taxable year.

Treasury regulations give an example of a widow who acquired by bequest from her husband the right to receive renewal insurance commissions on policies her husband had sold while he was alive. Under the terms of the insurance company agreement, the renewal commissions were payable over a period of years. Section 691 did not come into effect at this point since there was no estate tax due at the time of the husband's death; the marital deduction eliminated any tax liability. The widow died before all the commissions were paid and left them to her son. The example indicates the commissions the widow had received on her husband's behalf were IRD and includible in her gross income in the period of receipt (while she was alive). However, any commissions of renewal fees the son later receives are not includible in the widow's gross income, Instead, they are includible in the son's gross income in the period he receives them.

IRD in the form of unpaid earned income, accrued in come and payments from tax-sheltered retirement plans of a cash-basis decedent is easy for CPAs to identify because it represents fixed or contractual obligations in place at the time of the taxpayer's death. However, a more complicated type of IRD occurs where the decedent's right to receive the item is less certain. For example, payments a decedent's surviving spouse receives outside any employer's contractual obligations to the decedent, such as discretionary bonuses declared at the end of the year in which he or she died, have produced conflicting court decisions.

In Estate of O'Daniel, the Second Circuit Court of Appeals decision did not turn on whether the decedent had an enforceable right. Rather, the Second Circuit looked at the nature and origin of the payment. As long as it was compensation for the decedent's economic activity on behalf of the employer, the payment was IRD. In opposing viewpoints the Fifth Circuit Court of Appeals in Trust Co. of Georgia v. Ross and the Sixth Circuit in Keck both held the decedent's enforceable right was crucial in classifying such a payment as IRD. The question remains unsettled at the U.S. Supreme Court level.

In a private letter ruling, the IRS addressed a situation where a trust was the beneficiary. A taxpayer willed his IRAs to two different trusts. After his death his wife claimed her elective share of his estate under state law. The IRS, basing its decision on Kincaid v. Commissioner, determined the IRA distributions were IRD. Since the decedent's estate was subject to estate tax, the distributions to the wife, her estate (which received distributions after her death) and its beneficiaries were entitled to a section 691 (c) deduction for the estate tax attributable to the inclusion of the items in the husband's gross estate.

REPORTING IRD

In keeping with the spirit of fair and equitable treatment of IRD included as gross income, Congress has allowed IRD to retain the character it would have had in the decedent's hands. Income the decedent would have reported as ordinary income is classified as such in the recipient's hands. Income that would have been long-term capital gain to the decedent is long-term capital gain to the recipient. Additionally, IRD-related deductions and credits the law would have allowed to the decedent had he or she lived and paid the same expense (but that were not properly allowed in any of the decedent's tax years) are allowed to the recipient when paid. Combined with the itemized deduction for estate taxes attributable to IRD, these provisions eliminate much of the technical difficulty associated with such income under prior law.

IRD ESTATE TAX DEDUCTIONS

As noted above the law allows a beneficiary to deduct an amount equal to any estate tax attributable to IRD as an itemized deduction in the year the recipient includes the IRD on his or her income tax return. Where a decedent dies owning an IRA, it is possible the beneficiaries may receive IRA distributions for many years. As a result practitioners should be careful to make an accurate calculation of the estate tax attributable to IRD and the associated item

CPAs can calculate estate tax attributable to IRD using the concept of "net value" of IRD items included in the decedent's gross estate. This amount is the gross value of IRD items net of allowable IRD-related deductions and credits. Estate tax attributable to IRD then is the excess of the actual estate tax over an "as if" estate tax computed without including the net value of IRD in the gross estate. Where multiple IRD items are involved, the deduction is allocated among them.

Example 1. Tom died in 2004 leaving his estate as beneficiary of his IRA. At the time of his death, the IRA was valued at $1,500,000; his taxable estate was $4,750,000 (including the IRA). The estate tax is $2,100,800 before the unified credit. The as-if estate tax excluding the IRA is $1,380,800, also before the unified credit. The difference between these two tax liabilities ($720,000) represents the estate tax attributable to IRD. The recipient of the IRA distributions can take this amount as an itemized deduction on his or her tax return.

The deduction on any income tax return is prorated based on the distribution for that year. If a beneficiary receives $150,000 this year, he of she should be allowed a corresponding deduction of $72,000 ($720,000 x $150,000/$1,500,000). If the taxpayer is in the 35% bracket, an income tax savings of $25,200 results. Assuming this situation continues, the total tax savings are approximately $252,000 (of 16.8% of the value of the IRA).

ALLOCATING IRD AMONG MULTIPLE BENEFICIARIES

Where multiple IRD items and multiple beneficiaries are involved, the amount of estate tax a recipient can deduct is calculated according to the ratio of the recipient's share of gross IRD reported as income to the total gross value of IRD items.

Example 2. Mary died leaving $15,000 in gross IRD as part of her estate consisting of earned but unpaid salary of $7,500, accrued CD interest of $3,000 and accrued passive rental income of $4,500. Additionally, Mary owed $1,500 in property taxes on the rental property. In accordance with her will, Mary's son received the accrued rental property income and associated expenses ($4,500 and $1,500, respectively), Her husband and a trust shared the remainder of the estate equally. The net value of IRD is $13,500 after subtracting the real estate tax liability from the gross value of IRD items. The estate tax, after including $13,500 of net IRD and adjusting for the unlimited marital deduction, is $784,760 at year 2004 estate tax rates. The as-if estate tax is $780,800. The excess of $784,760 over $780,800--$3,900--represents the estate tax attributable to IRD.

Given that the example involves different IRD items transferred to multiple beneficiaries, each item will retain the same character it would have held for the decedent. Also, the recipient can deduct any IRD-related expenses in the period he or she actually paid them. Exhibit 1, page 82, shows the allocation of the IRD estate tax deduction among beneficiaries.

AN EASILY AVOIDED MISTAKE

Once they understand the nuances, CPAs will not find the allocation calculation difficult. The real problem lies in the fact that tax practitioners might overlook the deductibility of IRD-related estate tax on a beneficiary's income tax return. If the CPA was the decedent's long-term adviser and continues in that capacity for the beneficiaries, the return will take the IRD deduction issues into account. However, if the IRD recipient uses a different accountant, he or she could potentially overlook the deduction. Unless the CPA specifically asks about the circumstances of the distribution, he or she is unlikely to handle it correctly. Preparers often simply see a distribution from an inherited IRA, report it and calculate the income tax liability--failing to take into account any associated IRD deductions. To prevent this problem CPAs can use a questionnaire like the one described in exhibit 2, above, to collect information about IRD-related distributions.

The amount of the omitted deduction could be substantial for larger estates. Failure to take an IRD-related estate tax deduction could easily result in client claims that the CPA is responsible for financial losses due to the omission. If caught in time, an amended return may solve the problem. However, the statute of limitations for claiming refunds is the later of three years from the filing date of the return or two years from the date the tax was paid. The error may not be caught during this time frame.

CPAs must take care to ascertain whether any of a taxpayer's income is derived from such sources. Since the taxpayer probably is not knowledgeable about IRD-related issues, it is necessary for accountants to obtain appropriate information by including a series of questions on the return preparation questionnaire. Exhibit 2 lists inquiries CPAs might find useful in discovering whether or not IRD exists. For clients who receive inheritances, any Form 706, United States Estate and Generation-Skipping Transfer Tax Return, that has been filed often provides important information. Otherwise, careful inquiries are essential.

BE AWARE

While the IRD deduction is not an issue for most clients, the frequency of its occurrence is increasing. Failure to recognize and take the allowed IRD deduction could result in large errors-and-omissions problems for not only the client but also the preparer. Practitioners can avoid this pitfall by being aware of the IRD issues involved and making sure their client information questionnaire is effective in raising red flags for IRD-related situations.

Exhibit 1: Effect of IRD Items on Recipients' Income Tax Returns

                Gross IRD      Character of
               reported on        IRD on
              beneficiary's    beneficiary's
Recipient/     income tax       income tax
Beneficiary      return           return
    (1)            (2)              (3)

Husband          $5,250       $1,500 Interest
                               $3,750 Salary

Son              $4,500           $4,500
                               Rental income

Trust            $5,250       $1,500 Interest
                               $3,750 Salary

Total           $15,000          $15,000

                Expense         Allocation
Recipient/      allocable        of estate
Beneficiary    to IRD item    tax deduction *
    (1)            (4)              (5)

Husband                          $3,960 x
                              ($5,250/$15,000)=
                                  $1,386

Son             $1,500          $3,960 x
               Real estate    ($4,500/$15,000)=
              property taxes      $1,188

Trust                            $3,960 x
                              ($5,250/$15,000)=
                                  $1,386

Total            $1,500           $3,960

* (Estate tax attributable to IRS) x (Reported gross
income 1 Total gross IRD items).

Exhibit 2: Questions to Help Determine IRD Deduction

1. Have you ever inherited anything from anyone?   Yes   No

2. Was the person you received the inheritance from
a deceased spouse?   Yes   No

3. Did the decedent have to pay estate taxes?   Yes   No   I don't know
If your answer is "Yes" go to item
4. If your answer is "No" go to item 6,
If your answer is "I do not know" go to item 5.

4. Do you have of have access to a copy of the decedent's
estate tax return (IRS form 706)?   Yes   No

If your answer is "Yes" please provide a copy of form 706 and go to
item 6

5. What is the decedent's name, and who handled his or her estate? Do
you know the deceased's Social Security number?

6. What type of property did you receive through your inheritance?

--Cash                       --Stocks
--Bonds                      --IRAs
--Retirement plans           --Unpaid salary
--Unpaid bonus               --Renewal commissions
--Accounts receivable        --Notes receivable
--House                      --Land
--Annuity                    --Deferred compensation
--Gain from the sale         --Lottery annuity
  of an asset if payment
  was received after death

Other (describe):--

(Continue with the other questions on your interview sheet.)

IRD Exceptions

Certain "specified terrorist victims" may be exempt from the rules concerning income in respect of the decedent. CPAs should consult Publication 3920, Tax Relief for Victims of Terrorist Attacks, and Publication 559, Survivors, Executors, and Administrators, for additional information.

Source: www.irs.gov.

Historical Development of IRD

Prior to 1934 IRD items escaped federal income taxation. They were viewed as part of the gross estate subject to estate tax, not as income to the estate or its beneficiaries. This treatment allowed large amounts of income to go untaxed. In 1934 Congress put a stop to this by requiring all income accrued to a decedent at death to be reported as income on the decedent's final in come tax return. This resulted in the income's being taxed even though the deceased had not yet received it. In essence the provisions treated cash-basis taxpayers as accrual-basis taxpayers and clearly ignored a basic tenet of taxation: the wherewithal-to-pay concept.

A fundamental principle of taxation. this concept rests on the belief that one should be taxed on a transaction when he or she has the means to pay the tax. Under the 1934 provisions, a decedent's death accelerated IRD income recognition from the period it originally was scheduled to be received to the period of the decedent's final return. Given that actual receipt of the income might have been scheduled to occur several years later, it often became difficult for taxpayers to pay tax on the accelerated income.

Accelerating all income recognition to the decedent's final tax return resulted in a "bunching" of income in a single period. The result? Both the accelerated income and all other taxable income on the decedent's final return potentially became subject to higher tax rates in the progressive income tax system.

PRACTICAL TIPS TO REMEMBER

* You should always ask tax clients about assets they have inherited so you can properly reflect the potential income tax consequences.

* Carefully review the provisions of IRC section 691 to gain a clear understanding of what the term income in respect of the decedent (IRD) means. It can help ensure you properly reflect it on a client's income tax return and help him of her gain the full benefit of the deduction.

* Review relevant court cases carefully and take into account the fact that each circuit court of appeals may treat key issues differently.

* You can use the "net value" concept to calculate the amount of estate tax attributable to IRD. The difference between the actual estate tax and an as-if tax computed without including the net value of the IRD property in the gross estate is the estate tax attributable to that property.

* To make sure you don't omit any IRD deductions from a client's tax return, you should modify your return preparation questionnaire to include questions about this issue and request a copy of the relevant form 706.

RAYMOND A. ZIMMERMANN, PhD, is associate professor of accounting at the University of Texas at El Paso. His e-mail address is [e-mail]. PAT EASON, PhD, is associate professor of accounting at the University of Texas. Her e-mail address is [e-mail]. ANNE LEAHEY is assistant professor of accounting at the same university. Her e-mail address is [e-mail].