Your clients likely appreciate how you have helped them amass their nest egg. Feeling more secure, their focus may well shift to determining how to pass along those assets to their heirs. Many clients have concentrated wealth within retirement accounts that they will not need to spend during their lifetimes. It is your job to help your clients decide how to handle those assets. Should they just name their spouse, children, or a trust as beneficiary? What are the tax ramifications of passing on retirement accounts?
Due to the current publicity on estate tax legislation, many clients may be taking a “wait-and-see” approach to estate planning. While I cannot predict what our estate tax system will look like in the future, I do know that clients should address now a number of planning issues to maximize the value of assets that will pass to heirs.
One issue that is often overlooked during planning discussions is how best to plan for assets that are subject to income in respect of a decedent (IRD). IRD can be confusing, but I hope this discussion will add some clarity, in addition to presenting you with some new planning opportunities.
What Is IRD?
Treasury regulations define IRD 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)). So, with this definition and Internal Revenue Code Section 691, we are left to identify and administer assets that, upon the owner’s death, will produce an immediate ordinary income tax liability to the recipient of the asset. Rather than being solely concerned with planning for estate tax liability that assets may create upon a client’s death, it is important to recognize IRD items when implementing a plan for an efficient final distribution to heirs.
Implementing a client’s estate plan requires more than retitling a few brokerage or investment accounts into the name of a trust. As the investment expert on a client’s estate planning team, you must understand the roles that certain assets will play within the plan and how to best position those assets. IRD items require extra attention, but with some planning, the impact from the immediate ordinary income tax liability to the recipient can be lessened.
Examples of some typical assets or agreements that are IRD items include deferred compensation plans (both qualified and nonqualified), U.S. savings bonds, annuities, and uncollected payments prior to death under an installment sale. The identification of IRD items reaches far beyond these examples, but, for this discussion, I am only focusing on qualified deferred compensation plans and similar retirement accounts that are commonly a significant portion of client assets.
IRD and the Estate Tax
Under IRC Section 691, tax paid on IRD items provides an income tax deduction in relation to the federal estate tax paid on the portion of IRD items included in the gross estate. Unlike most property, which includes a step-up in basis upon the death of the owner, IRD items do not receive this step-up and are thus subject to estate and income taxation. The estate tax deduction attributable to IRD items provides some form of reprieve from the double taxation that would otherwise exist if not for the deduction. In many cases, however, the deduction from estate tax attributed to IRD items does not place the value of the estate in the same position as it would be with prior planning for disposition for IRD items.
Determining the true value of the estate tax deduction requires you to analyze the marginal tax rate of the recipient of the IRD item and the estate tax rate applied to the gross estate, among other factors. Moreover, because no portion of state death taxes paid is deductible for federal income tax purposes, you must consider the tax laws of each client’s particular state. Although there is a federal estate tax deduction for IRD items, the only way to ensure the value of the estate is maximized for the heirs is with prior planning for those same IRD items.
What’s the Plan?