James W. Coleman Sr., president of Coleman Financial Advisory Group in Waterbury, Conn., is on a mission -- and he thinks you should be too. "The IRD tax is a ticking time bomb for many people. It lays waiting, building up, getting ready to explode," he says. "Without proper planning and forethought, a family could lose a good portion of their estate planning benefits. The government could end up confiscating 35 percent to 60 percent of the wealth they hoped to pass on to their heirs."
IRD -- income in respect of a decedent -- is income a decedent earned and was entitled to receive but never actually received before his or her death. A typical IRD asset is the decedent's last paycheck for wages not paid until after death. Because the decedent's tax year closes on his or her death date, these funds aren't included in the decedent's income on his or her final tax return. As an item of IRD, the paycheck is included in the decedent's estate for estate tax purposes. In addition, it is taxed as ordinary income to whoever receives it. Essentially it is double-taxed, although you do get to take a portion of the IRD taxes paid as a credit against your estate taxes.
Unlike most assets included in an estate that receive a step-up in basis -- such as stock with a low income-tax basis or a personal residence -- IRD assets don't receive a new basis at death. So they are subject to both income and estate tax. This double tax burden can surprise beneficiaries who were unaware that they will owe income tax on these assets.
Income in respect of a decedent includes:
o Uncollected salaries, wages, bonuses, commissions, vacation pay, and sick pay of a cash-basis employee
o Certain deferred compensation and stock option plans
o Qualified pension plans, profit sharing plans, SEP, Keogh, and IRA plans (except nondeductible contributions)
o Accounts receivable of a cash basis sole proprietor
o Interest and dividends accrued but unpaid at death of cash basis decedent
o Rents and royalties accrued before death of cash-basis taxpayer
o Gain from the sale of property if the sale is deemed to occur before death, but proceeds are not collected until after death
o Difference between the face amount and the decedent's basis in an installment sale obligation
o Interest accrued through the date of death on Series EE bonds, unless (1) decedent elected to report interest annually, or (2) the interest was reported on the decedent's final Form 1040
o Annuity payments in excess of decedent's investment in the contract
After reviewing 14 pages of U.S. Tax code (IRS Publication 559, www.irs.gov/publications/p559/ar02.html), three pages from Estate Planning and Taxation (a book by John C. Bost, a professor in the department of finance at San Diego State University who holds a juris doctorate and a master's in taxation), and two pages of explanations with a chart generated via financial planning software -- all compliments of Coleman -- I reached for the Tylenol bottle and fought the urge to take a nap. I called Coleman instead.
"IRD retains the same character in the recipient's hands as it would have had in the decedent's hands had he or she lived to receive it," Coleman explains. "Items that would have been ordinary income to a decedent are ordinary income to the estate or other recipient. The problem is that the inherited dollars can force the recipient into a higher and unanticipated tax bracket, and the income taxes must be paid by the end of the tax year in which it was received.
"IRAs and other qualified retirement plans are other common examples of property subject to IRD when received by a beneficiary," Coleman continues. "Additional types of IRD include the decedent's unpaid bonuses, deferred compensation benefits, uncollected proceeds of a sale made before death, accrued but unpaid interest, dividends and rent, unpaid fees and commissions, and uncollected payments on an installment note.
"Some aspects of IRD are more difficult to deal with," Coleman says. "For example, imagine Anna Nicole Smith signing a deal with a company to pay her $5 million -- $1 million up front and $1 million annually for the next four years -- guaranteed. Shortly after depositing the first check, she dies. Her heirs would have IRD tax on the remaining $4 million."
An extreme example, perhaps; but even regular folks can be surprised at how much their estates may owe in taxes if they have not prepared. Think of a teacher who after 30 years has $200,000 tucked away in her tax-sheltered annuity. The interest she's built up can be a shock to heirs who'd appreciate receiving every cent possible.
"IRD taxes are often triggered when a qualified plan does not pass directly to a spouse," Coleman says. "Imagine that Dad has $150,000 accumulated in an IRA. Mom's already dead, and Dad hasn't done an especially good job planning ahead. Because the IRA does not pass to a spouse, it is taxed at ordinary income rates so up to 35 percent could be siphoned away. The $150,000 may also be subject to estate tax. Even with the credit for a portion of the IRD taxes paid, liquidity could become an issue, as the taxes will be due and the heirs may be forced to sell assets in a down market."
Coleman has seen first hand how IRD taxes can surprise a family. "In the 1990s, I met with a dairy farmer. While I tried to convince him, this man did not believe in buying life insurance to mitigate what would eventually become a $975,000 tax burden. While his two sons inherited the family farm, they also inherited this rather large tax. They couldn't take on more debt, so were forced to sell livestock and equipment to pay the tax. To make matters worse, the dairy industry was experiencing problems. Margins were down. Milk yield was down. The business spiraled down. Eventually they had to sell land. Today the farm can only support one brother and his small family. Life insurance could have been held in a trust to pay the taxes. Through foresight and planning, they could have been OK," Coleman says. "The life insurance premiums would have cost significantly less out-of-pocket than the cost of the tax."
Estate planning solutions include but are not limited to:
o Filing the correct beneficiary designations
o Making the right distribution elections
o Implementing a minimum distribution plan
o Dividing the estate as equally as possible to take full advantage of spousal exemptions
o Annual gifting to individuals to reduce the size of the estate
o Gifting directly from an IRA to a charity (provision currently set to expire at the end of 2008)
o Funding for the inevitable estate tax through life insurance
o Taking advantage of the section 691(c) deduction by which the participant and the designated beneficiaries can extend the distribution of the retirement assets over their full life expectancies (a.k.a. "stretch IRA")
Coleman says that the best planning is always done when both spouses are still alive -- otherwise they may lose some of the best opportunities available to them to pass on their assets tax-free. "It is always better, in my opinion, to do the retirement planning first and then create the estate planning documents," he adds. Still, no matter where your clients are in the planning process or in life, some planning is always better than no planning. "There are still options for a surviving spouse," Coleman says. "It's our job to educate the public and help people weigh their options."
Marie Swift is president of Impact Communications, a marketing and communications firm for independent advisors; see www.impactcommunications.org.