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Income in respect of a decedent: minimizing the double taxation.

Generally, Sec. 1014(a) provides that property acquired from a decedent has a basis equal to its fair market value (FMV) on the date of the decedent's death. Consequently, on the subsequent disposition of such property, neither the estate nor the beneficiary will pay income tax on appreciation existing at death. However, a notable exception exists under Sec. 1014(c) for property that constitutes a right to receive an item of income in respect of a decedent (IRD). According to Regs. Sec. 1.691(a)-1, such property consists of income items that the decedent was entitled to receive at death, but which were not properly includible in his taxable income for the tax year ending with the date of death or a prior tax year under his method of accounting. Although IRD items are fully includible in the decedent's gross estate, they receive no basis adjustment; instead, the decedent's basis carries over to the IRD recipient, who must pay income tax when the income is recognized. Limited relief from double taxation is provided under Sec. 691(c), which allows the recipient to deduct the estate tax paid attributable to the inclusion of the IRD in the decedent's estate. This deduction is available only if there is a taxable estate, and only if the IRD bears tax.

Proper tax planning is necessary to minimize the double taxation of IRD items in an estate. No single strategy can be employed to deal with the tax impact of IRD effectively. One strategy might be to ensure that the IRD will be taxed to a lower-bracket beneficiary. This can be accomplished either by having the IRD item pass directly to such beneficiary or by having the estate make a distribution of IRD in the year of receipt to one or more beneficiaries. This action is particularly important in view of the compression of the estate and trust income tax rates by the Revenue Reconciliation Act of 1993 (RRA). Under See. 1(e), the 36% tax bracket now applies to taxable income in the $5,501 to $7,500 range; all income in excess of $7,500 is taxed at a marginal rate of 39.6%. Another strategy might be to defer income recognition over a period of years.

This article discusses the types of income that frequently qualify as IRD items and the various provisions that affect their taxation; covers deductions in respect of a decedent (DRD) and the deduction for estate taxes paid on IRD; explains the pitfalls and offers planning ideas to deal with various types of IRD; and analyzes techniques to minimize IRD taxation (e.g., the funding of both charitable and other bequests with IRD items and the selection of a tax year).

Scope of IRD

The concept of IRD stems from Congress's desire to ensure that all income accrued by a cash-basis decedent prior to death ultimately bears income tax. Further, under Sec. 691(a)(3), IRD also incorporates the notion that the character of income as taxed to the recipient should be the same as if the decedent had lived to receive it. The dimensions of IRD are broader and more elusive than the Code and regulations seem to imply.

The courts have frequently been called on to establish the parameters of IRD. For example, in Est. of Peterson,[1] the Tax Court used several requirements to determine whether post-death sales proceeds were IRD: whether (1) the decedent entered into a legally significant arrangement, such as a contract, prior to death; (2) the decedent performed substantive nonministerial acts required as preconditions to the sale; (3) any economically material contingencies might disrupt the sale; and (4) the decedent would have eventually received the sales proceeds had he lived.

Example 1: A contract of sale is entered into to sell a shopping center. The contract requires the correction of several small municipal violations. At the seller's death, most, but not all, of the violations have been corrected. After the decedent's death, the sales price of the contract is renegotiated to allow for the additional corrective work. The sales proceeds are not IRD.

Had all work been completed to meet municipal inspection standards so that only the closing remained after death, the sales proceeds would have been IRD.

Whether a sales transaction has proceeded sufficiently far for the proceeds to be IRD is often difficult to determine. Each case must be individually examined to determine whether the Tax Court criteria have been met.

Under Sec. 691[a)(1) and Regs. Sec. 1.691(a)-1, a receivable is IRD if (1) the item would have been taxable to the decedent had he lived to receive it, (2) the item was not properly includible in the decedent's final return, (3) the item represents a passive right to receive income (as opposed to a property right) and (4) the right to receive the income was obtained by the recipient solely as a result of the death of the creator of the right.

Categories of IRD

Most IRD can be divided into four distinct categories: compensation, investment income, sales and partnership investments.

* Compensation for services

The unpaid salaries, wages, bonuses and commissions of a cash-basis decedent who was an employee are all IRD items.[2] Deceased employees' entitlement to payments for unpaid vacation and sick pay are similarly treated.[3] These items usually pass directly to a surviving spouse or other family member; generally, the amount is not large and provides little tax effect.

Example 2: G died on Mar. 20, 1995. At that time, G's employer owed him a month's wages, two weeks of vacation pay and a month's sick pay. B, G's wife, receives G's remuneration and includes it on their 1995 joint return. The income tax effect will be as if G had worked for an additional 2 1/2 months during the calendar year. The remuneration will also qualify as property passing to B and included in computing the estate tax marital deduction.

Deferred compensation arrangements can also produce IRD. As shown in Regs. Sec. 1.691(a)-2(b), Example 1, if the employee dies while some of the postponed payments remain unpaid, the unpaid amounts are IRD items. Regs. Sec. 1.421-8(c)(4)(iii) provides that if an incentive stock option (ISO) is not exercised by the decedent's estate or beneficiary, it is property that constitutes a right to receive IRD. Under Sec. 421(c)(1), if the estate or beneficiary exercises the ISO, no income is recognized on receipt of the stock, but is recognized on disposition of the stock. If an employee dies holding unexercised nonqualified stock options, this difference is IRD in all cases.

IRD includes any account balances in the decedent's qualified pension and profit-sharing plans and individual retirement arrangements (IRAS),[4] as well as a lump-sum distribution from a decedent's IRA that consists of both deductible and nondeductible contributions. However, the decedent's nondeductible contributions are excluded from the total.[5] For corporate executives with generous retirement benefits, it is not unusual for these retirement-related IRD items to be the principal assets in their gross estates.

The right to receive compensation does not have to be fixed at the time of death. A mere expectancy or substantial likelihood of receiving a payment is sufficient to cause the item to be included as IRD.[6]

Similar rules apply to the compensation-related income of self-employed cash-basis individuals. Typical IRD items include fees earned by a cash-basis professional prior to death[7] and insurance renewal commissions.[8] Keogh plan balances may also be significant IRD items.

A surviving spouse should normally be the beneficiary of retirement plan funds, because the funds can then be rolled over into the survivor's IRA.[9] Thus, payments from a retirement plan can be spread over a number of years and perhaps be taxed at lower rates than if the estate, or another family member, were the pension plan beneficiary.

When salary, bonuses and other items of compensation are paid to family members or to the estate, Sec. 101(b) provides a possible death benefit exclusion. The first $5,000 received that is not a gift from the decedent's employer is eligible for the exclusion. When multiple beneficiaries receive payments, the $5,000 must be allocated among them in proportion to the compensation received.

Investment income

Generally, all interest accrued but uncollected at death by a cash-basis decedent is IRD; consequently, the recipient is taxed when the interest is received. The IRD associated with interest accrued on Series EE savings bonds depends on whether the decedent made a Sec. 454(c) election to accrue and report annually the interest earned each year. If the election was made, the interest accrued for the year of death is reported on the decedent's final return; no IRD exists. IRD is also avoided if the executor makes a Sec. 454(c) election to report all interest accrued up to the date of the decedent's death on the decedent's final return.[10] The absence of either election results in IRD of the difference between the month-of-death redemption value of the bonds and their total purchase price.[11] The recipient then has the option of (1) waiting until some (or all) of the bonds mature or are presented for redemption to report IRD or (2) electing to recognize all the IRD in the year the bonds are received and reporting all subsequently earned interest under the accrual method.[12] If the recipient elects to report the interest when the bonds mature or are presented for redemption, the bonds could be selectively redeemed in years in which the recipient is in a lower bracket.

Example 3: J inherited $100,000 of Series EE bonds from his grandfather. Interest accruing on the bonds has never been reported on an income tax return. J plans to selectively redeem the bonds in years when he has larger-than-normal itemized deductions that can be used to offset the interest income.

Dividends do not accrue daily, even if the corporate payee has paid regular dividends on an uninterrupted basis for many years. Shareholders have no legal right to receive a dividend until it is declared by the board of directors. Further, a particular shareholder is not entitled to a dividend payment unless he owns stock on the record date. If a shareholder dies on or after the payment date, the dividend is taxable to him on his final return. Consequently, the right to receive a dividend is an IRD item only if death occurs on or after the record date and before the payment date.[13] Generally, the amount of IRD attributable to dividends is not large. Because of the timing of record and payment dates, the estate will generally collect the dividends, unless the stock is jointly owned. Small distributions to the residual beneficiary could allow the estate to transfer the income tax burden for such IRD to a lower-bracket beneficiary.

Example 4: M dies during the year. Her estate includes the stock of companies that have declared dividends that are IRD items. M's will provides that after certain specific bequests, the residue of the estate is to pass to her two children. The executor collects the dividends and makes some small preliminary distributions to the two children before the close of the estate tax year. The distributions carry with them the IRD from the dividends.

Rental income accrued but unpaid at death is IRD if the decedent was a cash-basis taxpayer.[14] However, rental IRD is somewhat rare, because most rent is prepaid and, thus, includible in a cash-basis decedent's final tax return. Royalty receivables applicable to the period before death are also IRD receivables.[15]

Sales proceeds

If death occurs after the sale of appreciated property and a portion of the sales proceeds remains unpaid at death, the outstanding receivables are IRD items. According to Regs. Sec. 1.691(a)-5(a) for an installment obligation under Sec. 453, the difference between the face amount of the obligation and the decedent's basis is IRD. Because no basis step-up occurs, the recipient of the installment receivable reports the same amount and character of income when a payment is collected that the decedent would have reported had he lived to receive the payment. The Eighth Circuit recently concluded in Frane[16] that if installment receivables are automatically canceled on the decedent's death, the estate recognizes taxable income. This reversed the Tax Court's decision that the income was taxable to the decedent on his final return and, thus, there were no IRD consequences The Tax Court had reasoned that the cancellation constituted the disposition of an installment obligation that was taxable income to the decedent under Sec. 453B(f), and not a nontaxable transmission of an installment obligation at death. However, citing the clear language of Sec. 453B(c), the Eighth Circuit ruled that a cancellation that occurs at the obligee's death is a transfer of an IRD item by the estate. Further, no deduction for estate taxes paid attributable to the installment receivable was available, because the receivable was not includible in the decedent's gross estate.[17]

Example 5: A sold her home to her son B in return for an installment note and used the annual proceeds to help cover the cost of her apartment in a retirement community. The note will be canceled on A's death. Any unrecognized gain on the installment note at A's death will be includible as an IRD item on the estate's income tax return. Estate taxes paid cannot offset this IRD item.

If the decedent had elected out of installment sale treatment under Sec. 453(d), there would be no IRD, because the entire gain would have already been reported by the decedent on his income tax return for the current or a prior tax year.

If death occurs after sales negotiations have begun, but before the sale is closed IRD can be avoided. The property's basis becomes its date-of-death FMV and the property can be sold by the estate or a beneficiary with little or no gain recognition. This result will occur only if, at the time of the decedent's death, the transaction had not progressed such that, for tax purposes, it was deemed to have already occurred, a difficult determination to make.

The formal passage of legal title does not necessarily control for purposes of this determination; the courts have employed both an "economic activities test" and a "right to income" test. Under the former, IRD exists when the post-death payments received are principally due to economic activities and services performed by the decedent and those performed by his successors are of little or no material significance (i.e., are merely ministerial).[18] The focus of the "right to income test" is whether the decedent was entitled to receive the income in question at the date of death; if the decedent was so entitled, IRD exists. The latter test grew out of the conclusion that absent a right to receive the income in question, IRD could not exist, regardless of the effort expended by the decedent.[19] As previously discussed, IRD does not exist if substantial conditions remain to be fulfilled by the seller at the time of his death. For example, in Est. of Napolitano,[20] the proceeds of a realty sale were not IRD because the decedent had not corrected all housing code violations required by the contract of sale. Additionally, the IRS has held that the proceeds from a short sale initiated by the decedent were not IRD when the closing of the sale by delivery of the stock did not occur until after the decedent's death.[21]

* Partnership items

Several IRD items can arise in conjunction with a decedent's ownership of a partnership interest. Absent a buy-sell agreement to the contrary, a partner's death does not cause the partnership's tax year to close with respect to such partner.[22] Consequently, Regs. Sec. 1.706-1(c)(3)(ii) provides that the decedent's final return includes only his share of partnership income for the last partnership tax year that ended before his death. A decedent's distributive share of partnership income for the partnership's tax year that ends after his death is includible in the return of his estate or other successor in interest.[23] Any portion of this distributive share that pertains to the period before the decedent's death is IRD.[24] The balance of the distributive share is income to the decedent's successor but is not IRD. Contrary to the normal IRD scheme, this income is recognized in the successor's tax year that includes the partnership's year-end, whether or not the income is actually distributed. This can impose a hardship on the successor if the decedent had taken large draws from the partnership before his death. In such case, the successor will pay income tax on the full distributive share, even if he actually receives little or no distributions from the partnership.[25]

The courts have created another category of IRD in a partnership setting, using the aggregate theory of partnership taxation to deny a basis adjustment to FMV for a partnership interest that includes IRD-type receivables. In Quick,[26] the partnership made a See. 754 election in an attempt to increase a partner's estate's basis for its share of partnership accounts receivable. The Tax Court held that the receivables were zero-basis IRD items; consequently, the estate was forced to recognize a pro rata share of ordinary income as the partnership collected the receivables. A similar approach was used by the court in Woodhall.[27] There, the partners had entered into a buy-sell agreement that dissolved the partnership on the death of a partner. The decedent's estate attempted to take a basis step-up for the partnership interest and reported no gain on the sale. Employing the aggregate theory, the court denied a basis step-up to the extent of the date-of-death FMV of the deceased partner's interest in the partnership's accounts receivable. As a result, the estate recognized ordinary income on the sale, representing the deceased partner's share of accounts receivable.

Partnership payments in liquidation of a retired or deceased partner's interest may result in IRD. To the extent that liquidating distributions are made as payment for Sec. 751(c) "unrealized receivables" and goodwill (unless otherwise stated in the partnership agreement), IRD exists.[28] Consequently, basis step-up is denied at death and ordinary income is recognized on subsequent collection. On the other hand, to the extent that the payments represent the price paid for the decedent's interest in partnership property other than Sec. 751 hot assets, IRD treatment is avoided.

Example 6: T retires from a law practice. As part of the partnership agreement, T is to receive $80,000 per year for 10 years; $20,000 of each payment is in return for partnership property. The balance of the annual payments represents unrealized receivables and goodwill. At T's death, four years of payments are owed and payable to T's estate. The remaining payments to be made for partnership property ($20,000 x 41 receive a step-up in basis at death. The part of the payments representing unrealized receivables and goodwill ($60,000 x 4) are IRD items and do not receive a basis step-up. They are includible in income when received by the estate and are deductible by the partnership as guaranteed payments.

Historically, partners and partnerships have enjoyed considerable discretion in identifying payments as either property payments (Sec. 736(b)) or nonproperty payments (Sec. 736(a)), as long as the total payments allocated to property did not exceed the property's FMV at the date of death or retirement.[29] However, to curtail partnership deductions, RRA Section 13262 limited this latitude in some cases. Effective for partners retiring or dying after Jan. 4, 1993, generally, liquidating payments in exchange for unrealized receivables and goodwill are treated as made in exchange for the partner's interest in partnership property (i.e., as Sec. 736(b) payments). Consequently, the payments are not IRD to the recipient, nor do they give rise to a partnership guaranteed payment deduction or a reduction in the distributive shares of the remaining partners.[30]

Example 7: E was a general partner in a real estate partnership when she died in 1994. Under the partnership agreement, E's estate is to receive liquidating distributions of $10,000 per year for five years. Under current law, the estate will automatically receive a basis step-up for this installment receivable equal to its date-of-death FMV. Therefore, no income will be recognized by the estate unless the total payout it receives exceeds its basis. The partnership may not claim a deduction for the payments it makes to E's estate.

This legislative change does not apply to payments made to a general partner of a partnership in which capital is not a material income-producing factor. Thus, partnerships in law, accounting, architecture, medicine or dentistry still may designate payments as being property or nonproperty. In addition, service partnerships that also hold significant real estate assets and conduct fee-based businesses may want to segregate the fee-earning operations and the real estate into separate partnerships. This restructuring may enable the fee-based activity partnership to qualify for the more favorable tax treatment.

* S corporation items

A decedent's S corporation stock has no IRD impact. Sec. 1366(a) requires a shareholder to take into account his pro rata share of S corporation income or loss calculated through the date of death on his final return. Consequently, when the shareholder's share of S income is received by his successor, it does not constitute IRD, because it has already been taxed.[31] Likewise, the post-death sale or redemption of the decedent's S stock does not produce IRD, because the stock's basis is adjusted to FMV at death.

Congress recently considered making a substantial change in this area. Section 504(d)(4)(A) and (B) of the unenacted Tax Simplification and Technical Corrections Act of 1993 provided that the recipient, of S stock from a decedent could treat as IRD his pro rata share of any corporate item that would have been IRD had the item been acquired directly from the decedent.[32] Consequently, the recipient's basis in the stock would be reduced by the dollar amount of stock value attributable to the IRD. The proposal would have put the basis treatment of both partnership and S corporation interests that pass through a decedent's estate on an equal footing. Future enactment of a similar piece of legislation is quite possible and should be considered in any tax planning that involves S corporation stock ownership.


The concept of IRD causes income items of a cash-basis taxpayer that are earned but unpaid at death to be fully taxed to their ultimate recipient. To provide equity, Regs. Sec. 1.691(b)-1(a) also allows the following expenses, interest and taxes for which the decedent was liable to be deducted when paid, provided they were not deductible on his final return: 1. Ordinary and necessary business expenses (Sec. 162). 2. Deductible interest (Sec. 163). 3. Property taxes (Sec. 164). 4. Expenses for the production of income (Sec. 212). 5. Deductions for percentage depletion (Sec. 611). 6. Foreign tax credits (Sec. 27).

The first four types of expenses are also deductible for estate tax purposes under Sec. 2053(a) as claims against the decedent's estate. The double deduction of these items is justified by the fact that IRD is subject to both estate and income tax.

Typically, the decedent's estate is liable for the payment of DRD items. Consequently, the estate can take the deductions when it makes a payment. On the other hand, if a beneficiary receives property subject to a liability stemming from a DRD item for which the estate is not liable, Regs. Sec. 1. 691(b)-1(a)(2) allows the beneficiary to claim the deduction in the tax year during which he actually makes payment.

Sec. 691 does not specify that the character of a DRD item is maintained in the hands of the estate or other beneficiary. However, the Sec. 691(a)(3) character rule clearly supports the conclusion that these deductions maintain their identity. All Sec. 691(b) deductions, with the exception of depletion and the foreign tax credit, are miscellaneous itemized deductions. If the character rule applies, only DRD items related to ordinary and necessary business expenses (Sec. 162) and to the production of income (Sec. 212) are subject to Sec. 67(b)'s 2% of adjusted gross income floor.

Deduction for Federal Estate Tax Paid

As previously noted, IRD items are subject to both estate and income tax. To partially alleviate this inequity, Sec. 691(c) allows the IRD recipient an income tax deduction for estate tax paid that is attributable to inclusion of net IRD in the decedent's gross estate.[33] Under Sec. 67(b)(8), the deduction for estate taxes is a miscellaneous itemized deduction not subject to the 2% floor. Under Sec. 691(c)(2), the deduction is the excess of the actual Federal estate tax liability over the amount of estate tax that would be due if all IRD and DRD items were excluded from the gross estate. When IRD is recognized on a recipient's income tax return, Sec. 691 (c)(1)(A) provides that a proportionate amount of this difference is an itemized deduction on the same return. This approach is beneficial to an IRD recipient because the calculation uses the estate's highest marginal estate tax rate.

"Estate tax" is defined by Sec. 691(c)(2)(A) as the tax reduced by available credits. However, for this purpose, Sec. 691(c)(1)(C) provides that the portion of the estate tax attributable to an increase in the estate tax under the Sec. 4980A tax on excess accumulations in qualified pension plans is not deductible. If the decedent's estate is also subject to the generation-skipping transfer (GST) tax because of a taxable termination or a direct skip occurring at death, an estate tax deduction is also allowed under Sec. 691 (c)(3) for the portion of the GST tax attributable to net IRD. The deduction for the GST tax is computed as discussed above.

Regs. Sec. 1.691(c)-1(a)(2) provides that any estate tax deduction (e.g., the marital deduction) that is computed based on the size of the gross estate must be recomputed to take into account the exclusion of such value from the gross estate to properly determine the Sec. 691(c) deduction to which a recipient is entitled. Consequently, when the will bases the marital deduction on a percentage of the gross estate, the reduction in the size of the gross estate produces a corresponding decrease in the marital deduction. This approach serves to reduce the IRD deduction that would otherwise be available to the IRD recipient.[34] A specific bequest of IRD items to a spouse will cause IRD items to be excluded from both the gross estate and the marital deduction in the Sec. 691(c) deduction computation; therefore, no deduction for Federal estate taxes paid will be allowed.[35] By analogy, the same result should occur if IRD items are bequeathed to a charity. The Sec. 691 (c) deduction calculation provision apply to the GST tax. Thus, specific bequests subject to the GST tax are not included in the gross estate when the deduction is calculated.

Planning Obstacles and Opportunities

* Specific bequests

An estate is taxed as a complex trust. To the extent that distributions are made by the estate, IRD is carried out with the distribution as a part of the estate's distributable net income (DNI). Specific bequests of property do not carry out income and, thus, do not carry out IRD unless the will or other governing instrument directs that specific or pecuniary bequests be funded with IRD items. (A pecuniary bequest is a fixed sum of money expressed as a stated dollar amount, or as an amount determined by formula.)

The latter approach may be a very desirable planning technique when, for example, a partnership interest is a significant part of an estate and can be expected to generate considerable passive income. A specific bequest of the interest will often allow an actual distribution of the partnership interest to be made prior to the partnership year-end. Thus, rather than the estate, beneficiaries who can use the passive income being generated by that partnership will include the income for the entire year, including any IRD, in their individual returns.

In addition, if a family partnership is used for wealth transfers, a specific bequest of the general partnership interest retained by the decedent will often transfer all income for the year of death to a lower-bracket beneficiary. Such partnerships will be used increasingly to replace trusts as vehicles for holding and managing family assets, as they are true conduits that offer both flexibility and an effective means of avoiding the high trust income tax rates.

Specific bequests of other IRD items can also accomplish tax savings. However, an IRD item should generally not be used to satisfy a pecuniary bequest, as it will accelerate income recognition by the estate. The use of appreciated property to satisfy a pecuniary bequest results in the recognition of income (the difference between the FMV of the item and its basis in the hands of the decedent) by the estate. In addition, a distribution in satisfaction of a pecuniary bequest does not carry out with it estate DNI.[36]

* Distribution of IRD items

Early distributions from the residual estate can also help to shift IRD and other income to lower-bracket beneficiaries. However, a problem exists in that most state laws limit an executor's power to make distributions, other than specific bequests, prior to the time notice to creditors has expired. It may be necessary to obtain a court order before distributions can be made. One way to allow for the maximum time to make preliminary distributions is to select a fiscal tax year-end that produces an initial tax year of almost 12 months.[37] Under Sec. 441, estates can use a fiscal year for tax purposes.

* Using IRD to fund the marital deduction

Even if there is no estate tax, using IRD items to fund the marital bequest may be desirable. Property qualifying for the marital deduction in the estate of the first spouse to die will be included in the estate of the surviving spouse unless it is consumed or given to another during the remainder of the surviving spouse's life. By allocating IRD to the marital share of the estate, the surviving spouse will bear the income tax liability on this income. Thus, the value of the marital portion of the estate will be reduced. This approach will produce future estate tax savings because it reduces the size of the surviving spouse's gross estate at death.

In the authors' view, if the marital bequest is a pecuniary bequest, funding it with IRD will accelerate the IRD recognition, as previously noted. Thus, the IRD will be included on the estate income tax return, and will not be taxed to the surviving spouse or to the marital deduction trust. Care should be taken to avoid this result by expressing marital and nonmarital bequests as fractional shares in the wills of individuals whose estates consist of significant IRD.

* Using IRD for charitable bequests

An estate can deduct for income tax purposes any part of its gross income paid or permanently set aside for charitable purposes. A charitable deduction is not allowed for the distribution of principal or tax-exempt income to a qualified charity. To qualify for the charitable deduction, gross income from a probate asset must be distributed under a will. Sec. 642(c) provides that an actual income distribution must be made, or the income must be permanently set aside for the use of the charity, even though the charity is a residual beneficiary under the will.

In the case of a nonprobate asset (e.g., a pension plan), a charity may be named as the remainder beneficiary. Sec. 4980A states that neither a charitable deduction nor a deduction for taxes paid is allowed for the excise tax paid on an excess accumulation.(38)

If a will or other governing instrument specifically requires that charitable bequests be funded with IRD items, either the income associated with such items will be recognized by the charity and remain untaxed, or the estate will receive a charitable deduction for any gross income distributed or set aside for the charity, regardless of whether the bequest is pecuniary or specific. Care should be taken to ensure that any income is distributed to, or permanently set aside for, charity in the year of recognition by the estate so that the income recognition and charitable deduction off set each other on the same income tax return. Using IRD items to fund a charitable bequest does not reduce the charitable deduction otherwise available to the estate. However, it reduces the income tax ultimately paid by an estate and its beneficiaries. Therefore, charitable bequests of IRD items can produce favorable results.

Not all types of IRD are suitable to fund a charitable bequest. Partnership interests and S corporation stock will not produce the desired result of passing IRD to a charity. A deduction is not allowed to an estate for income recognized from a partnership, even if the underlying interest is distributed to a charity. This result stems from the fact that income or IRD from a partnership may never actually be paid or set aside for use by the charity.(39) The relinquishment of partnership liabilities on the transfer to charity may also produce income in the estate of the difference between partnership basis and the face amount of the liabilities. Further, since charities are corporations, under Sec. 1361(b)(1)(B), they would not be qualified S shareholders and, therefore, could not be the recipients of S stock.

Using IRD items to fund charitable lead trusts or charitable remainder trusts also results in income recognition to the estate, with no offsetting charitable deduction, if the estate collects the IRD items. Additionally, an estate will recognize income if IRD items are distributed to a charitable trust in satisfaction of a pecuniary bequest. Except in the case of a net income charitable remainder unitrust, this occurs because the distribution is normally not made exclusively for charitable purposes.[40]


The RRA's compression of estate income tax rates has increased the need to reduce income recognized and taxed in an estate. IRD can be a significant income item in an estate that is often recognized within a short period following death. Planning is necessary to ensure that this income will be taxed at lower marginal rates by using bequests or by making use of timely distributions to beneficiaries.

[1]Est. of Charley W. Peterson, 74 TC 630 (1980), aff'd, 667 F2d 67 (8th Cir. 1981)(49 AFTR2D 82-424, 82-1 USTC [paragraph]91 10). [2]See Regs. Sec. 1.691(a)-2(b), Examples 1 and 2. [3]Rev. Ruls. 59-64, 1959-1 CB 31, and 55-229, 1955-1 CB 75. [4]H. Lloyd Hess, 271 F2d 104 (3d Cir. 1959)(4 AFTR2D 5638, 59-2 USTC [paragraph] 9714); IRS Letter Ruling 9132021 (5/2/91). [5]Rev. Rul. 92-47,1992-1 CB 198. [6]Edward D. Rollert Residuary Trust, 752 F2d 1128 (6th Cir. 1985)(55 AFTR2D 85-685, 85-1 USTC [paragraph] 9139); Est. of Edgar V. O'Daniel, 173 F2d 966 (2d Cir. 1949)(37 AFTR 1249, 49-1 USTC [paragraph]9235). [7]Midland National Bank of Billings, 168 F Supp 736 (DC Mont. 1959)(3 AFTR2D 549, 59-1 USTC [paragraph]9185). [8]See Regs. Sec. 1.691(a)-2(b), Example 2. [9]Rev. Rul. 92-47, note 5. [10]Rev. Ruls. 68-145, 1968-1 CB 203, and 79-409, 1979-2 CB 208. [11]Series H bonds will also include IRD if Series E or EE bonds have been used to purchase them. Additionally, the increase in the value of Treasury bills over their cost is IRD. [12]Rev. Rul. 64-104, 1964-1 CB (Part 1) 223. [13]Rev. Rul. 64-308, 1964-2 CB 176. [14]See Rev. Rul. 64-289, 1964-2 CB 173. Although the ruling deals with crop rents, there appears to be no reason why rent received in cash should I;e accorded different treatment. [15]Rev. Rul. 60-227, 1960-1 CB 262. [16]Janet M. Frane, 998 F2d 567 (8th Cir. 1993)(72 AFTR2D 93-5268, 93-2 USTC 150,386), rev'g Est. of Robert E. Frane, 98 TC 341 (1992). Many commentators have found the Eighth Circuit's decision to be flawed. [17]Sec. 691(c). See the text accompanying note 33 for a discussion of the deduction for Federal estate tax paid. [18]Rose J. Linde, 213 F2d 1 (9th Cir. 1954)(45 AFTR 1522, 54-1 USTC [paragraph]9384), cert. denied. [19]Trust Co. of Georgia v. Ross, 262 F Supp 900 (N.D. Ga. 1966)(19 AFTR2D 489, 67-1 USTC [paragraph]9156), aff'd per curiam, 392 F2d 694 (5th Cir. 1967)(21 AFTR2D 311, 68-1 USTC [paragraph]9133). [20]Est. of Ernest G. Napolitano, TC Memo 1992-316. [21]IRS Letter Ruling 9319005 (2/4/93). Consequently, the stock received a basis step-up to date-of-death FMV. See also Rev. Rul. 73-524, 1973-2 CB 307. [22]Sec. 706(c)(1) and Regs. Sec. 1.706-1(c)(3)(i). [23]Regs. Sec. 1.706-1(c)(3)(ii); Rev. Rul. 71-271, 1971-1 CB 206. [24]See the examples at Regs. Secs. 1.706-1(3)(v) and 1.753-1(b). [25]See Regs. Secs. 1.706-1(c)(3)(vi) and (4); 1.753-1(b). [26]George E. Quick Trust, 444 F2d 90 (8th Cir. 1971)(27 AFTR2D 71-1581, 71-1 USTC [paragraph] 9489), aff'g per curiam 54 TC 1336 (1970). [27C]hrissie H. Woodhall, 454 F2d 226 (9th Cir. 1972)(29 AFTR2D 72-394, 72-1 USTC 919176), aff'g TC Memo 1969-279. [28]Secs. 753 and 736(a). [29]Regs. Sec. 1.736-1(b)(5). [30]Under Regs. Sec. 1.736-1(a)(4), payments are treated either as a distributive share of partnership income (if determined with regard to partnership income) or as guaranteed payments (if determined without regard to partnership income). [31]Rev. Rul. 64-308, note 13. [32]H. Rep. No. 103-353, 103d Cong., 1st Sess. 143 (1993). [33]Full equity would require a credit for the estate tax paid. [34]IRS Letter Ruling (TAM) 9219006 (1/31/92). [35]Regs. Sec. 1.691(d)-1(e), Example 2, and Rev. Rul. 67-242, 1967-2 CB 227. [36]For a comprehensive discussion of problems and planning arising from the distribution of IRD, see Barnett, "Income Tax Planning for Trust and Estate Distributions (Part II)," 24 The Tax Adviser 148 (Mar. 1993), at 151-152 (part 15). [37]A tax year must end on the last day of a calendar month. Therefore, an estate must end its first tax year by the last day of the month preceding the date of the decedent's death. [38]See Sec,691(c)(1)(C). [39]See Est. of Sanford H.E. Freund, 303 F2d 30 (2d Cir. 1962)(9 AFTR2D 1479, 62-1 USTC [paragraph]9476), and Sid W. Richardson Foundation, 430 F2d 710 (5th Cir. 1970)(27 AFTR2D 71-369, 70-2 USTC [paragraph]9483). See also Rev. Rul. 73-95, 1973-1 CB 322. [40]IRS Letter Rulings (TAMs) 8603002 (3/19/85) and 8810006 (12/10/87).
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Author:Strobel, Caroline D.
Publication:The Tax Adviser
Date:May 1, 1995
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