Over the past month, the financial planning community has been buzzing about the lack of action taken by lawmakers to reform the federal estate tax. What was once thought as impossible has turned into reality. The federal estate tax has been repealed for tax year 2010–for now–and a carryover tax basis has been instituted.
There are many commentators who believe that there will be a retroactive reformation of the estate tax, while there are others who believe a retroactive reinstatement of the estate tax would be deemed unconstitutional. It is difficult to say what will happen, although I believe a retroactive reinstatement is likely. Still, the lack of a resolution prior to the beginning of this year does not give us an excuse to ignore planning issues that remain–regardless of the outcome of the estate tax situation.
The repeal of the estate tax aside, 2010 introduces the concept of a carryover basis. The assets owned prior to death are no longer stepped-up to the fair market value at the date of death or the alternate valuation date. Capital assets received by heirs will carry the same tax basis as that of the deceased owner. The decedent's executor may allocate a basis increase of up to $1.3 million (but not above fair market value (FMV)) for property passing to nonspouse beneficiaries. Basis of property passing to a spouse may receive an increase of up to $3 million (but not above FMV).
Assets that are items of income in respect of a decedent (IRD), however, do not have a basis to carryover, nor can they receive an allocation of basis by the decedent's executor. It is upon these, at times-overlooked, IRD items where planning must continue to be a focus, no matter the status of the estate tax.
What is IRD?
In the Treasury Regulations, IRD is defined as "those amounts to which a decedent was entitled as gross income but which were not properly includable in computing his taxable income for the taxable year ending with the date of his death or for a previous taxable year under the method of accounting employed by the decedent" (Treas. Regs. ?1.691(a)-1(b)).
In more general terms, if a client dies before receiving income to which he or she was entitled prior to death, the income is not included on the client's final tax return. But the income and the tax liability associated with the income do not disappear. The item of income is characterized as income in respect of a decedent (IRD). The beneficiary, as recipient of the IRD item, must declare the IRD item as income when it is ultimately received.
Typical assets or agreements considered IRD items include qualified and nonqualified deferred compensation plans, IRAs, annuities, U.S. savings bonds, and uncollected installment sale payments.
IRD and the estate tax
Prior to the 2010 repeal of the estate tax, an income tax deduction was available to recipients of IRD items when the IRD item was included and taxed as part of the gross estate. Unlike capital assets that would receive a step-up in tax basis upon the death of the owner, an IRD item would not receive a similar step-up; consequently, the IRD item is subject both to income and estate taxation, even though the income tax deduction mitigated the overall tax burden otherwise associated with the potential "double taxation."
Currently, in 2010, there is no estate tax and therefore no income tax deduction where an IRD item is includable in the gross estate. And, with no form of step-up or allocation of basis afforded to the IRD item, financial planners must continue to focus on who is the most efficient recipient of an IRD item in any estate tax environment.
