If one thing is anathema to taxpayers and their advisers, it’s paying tax twice on the same income. Sometimes, they’ll twist themselves and the Tax Code into a pretzel to avoid it. Other times, the relief they seek is hiding in plain sight.
Such is the case with the deduction for federal estate tax on income in respect of a decedent, which simply is income that is earned before death but paid after death. It’s taxed to whoever receives it. In some cases, an estate will be the recipient; in others, it may be a designated beneficiary.
At its core, the IRD deduction is the mechanism ensuring double taxation is mitigated on the IRD that has been taxed under both the federal income tax rules and the federal estate and gift tax rules. For example, suppose Chip Saunders, a cash basis taxpayer with a gross estate valued at $20 million, died on Jan. 2, 2023. At the time of his death, he was due to be paid a $100,000 bonus on Jan. 31, 2023, for work done in December 2022. Under these circumstances, the $100,000 meets the definition of IRD. It’s subject to estate tax as an asset of the estate on Form 706, and it’s subject to income tax on the estate’s 2023 federal income tax return.
This deduction is referred to as the income in respect of a decedent deduction, but this is misleading because the deduction doesn’t equate to the amount of the gross IRD asset included in the estate. Rather, the deduction is based on the amount of federal estate tax that is generated by the IRD at issue.
Consequently, the effect of double taxation is only partially relieved. In other words, you get to deduct the estate tax paid on the IRD, not the IRD itself.
IRAs and IRDs
A decedent’s IRA, whose balances can run into the millions of dollars, is one item that will generate the IRD deduction. On larger estates, IRAs may also generate a substantial portion of the estate tax on Form 706. Because traditional IRAs may generate income tax when distributed to the estate’s beneficiaries, such distributions may be taxed both as an asset of the estate as well as income to the beneficiaries.
Let’s say an unmarried taxpayer died in 2023 leaving a taxable estate of $25 million, $2 million of which was a traditional IRA; the IRA is the estate’s only item of IRD; and the estate has one beneficiary. A taxable estate of $25 million will generate an estate liability of $10 million, of which $800,000 will be attributed to the IRA. When computing the IRD deduction, the income items attributable to it are included on a last in, first out basis. They’re deemed to occur after the estate tax exclusion is used, so the IRD is assumed to be found only in the taxable portion of the estate.
The deduction in the above example would be claimed by the IRA’s beneficiary, who also would be the estate’s sole beneficiary. The IRD deduction follows the income from the decedent to its ultimate destination—in this case, the personal tax return of the beneficiary. Often, the IRD income will be reported on the estate’s income tax return, during which the estate will take the corresponding IRD deduction on Form 1041.
In most cases, the IRD deduction will be deducted by the estate’s beneficiaries in the same year that the federal estate tax is paid by the estate. However, any IRD deduction that is associated with an IRA may present tracking and timing issues because the IRA may be distributed to the beneficiaries in increments after the death of the decedent over several years.
Because the IRD deduction can’t be claimed by the beneficiary until there’s a taxable distribution from the IRA resulting in tax, taxpayers (or more likely, their tax preparers) are faced with tracking and matching the IRD deduction to the IRA distributions in the year they occur.
Where and How to Take the Deduction
Prior to the Tax Cuts and Jobs Act, most pass-through deductions from an estate or trust were generally deducted as a miscellaneous itemized deduction on Schedule A of the taxpayer’s Form 1040. The TCJA added Section 67(g), which suspended the deductions of miscellaneous itemized deductions in excess of 2% of adjusted gross income for all taxpayers for the years 2018 to 2025 (inclusive).
There was some initial concern in the tax practitioner community that Section 67(g) would prevent estates and trusts from deducting certain expenses, including the IRD deduction. The IRS addressed this matter by saying:
“Nothing in Section 67(g) affects the ability of the estate or trust to take a deduction listed under Section 67(b). These deductions remain outside the definition of ‘miscellaneous itemized deduction.’ For example, Section 691(c) deductions (relating to the deduction for IRD), which are identified in Section 67(b)(7), remain unaffected by the enactment of Section 67(g).”
Therefore, until such time as further guidance is offered, it appears the IRD deduction should be taken on Schedule A of Form 1040 under “other miscellaneous deductions,” with the notation “federal estate tax on income in respect of a decedent.”
A final fact about this often overlooked and arcane deduction is that the estate doesn’t necessarily need to pay the estate tax for the recipient of the IRD to take the deduction. But estate tax must be incurred on Form 706 for the beneficiary or the estate to claim the deduction on their respective income tax returns.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
David Ellis is the managing partner of Ellis & Ellis CPAs, located in Pasadena, Calif. He specializes in divorce, trust, estate, and other family tax matters.
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