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PROPERTY ACQUIRED FROM A DECEDENT BENEFICIARY UNDER A WILL

What are the the income tax ramifications of property acquired from a decedent's estate?  What are the cost basis issues for an individual beneficiary/heir receiving inherited property?  This is an important area sometimes overlooked by executors and beneficiaries of a decedent's estate.  It is often incorrectly assumed that all inherited property receives a step up in basis to the fair market value of the property at the date of the decedent's death.

It is true that under the general rule of Code Section 1014(a)(1) the basis of property acquired from a decedent, which has not been sold, exchanged, or otherwise disposed of before the decedent's death, is stepped up (or down) to the property's fair market value at the date of the decedent's death.  There is an exception if the executor of the estate elects, for estate tax purposes, to value the decedent's gross estate at the alternative valuation date.  (IRC Section 2032)  The basis of property in a beneficiary's hands in that case would be the fair market value at the appropriate alternative valuation date.  The alternative valuation date is the date six months after the decedent's death, or if the property has been distributed within six months, then value as of the distribution date.  If no estate tax return is required to be filed, the alternative valuation date is not applicable pursuant to Regulation 1.1013-3(a) because of the lack of an election.  Even without an estate tax return the rule of Code Section 1014(a)(1) controls, that is, the cost basis of property in the hands of the beneficiary will be the fair market value of the property as of the decedent's death.

The rule partly applies to inherited portion of property owned by a taxpayer jointly with the deceased; but not the portion of jointly held property that the inheriting taxpayer owned before his inheritance.  The inheriting taxpayer does not receive a step up in basis as to the portion of the property already owned by the inheriting taxpayer at the time of the decedent's death.  Therefore, as to jointly held property with one other person (the decedent), one-half (50%) of the property receives a step up in basis to FMV.

It is crucial that cost basis and gifting rules be understood so that disastrous tax errors are not made.  For example, mistakes are often made when property is gifted to a family member prior to death.  In a lifetime gifting situation the beneficiary takes the donor's cost basis and the step up rules do not apply.  There can be serious income tax ramifications on the eventual sale of gifted property by the donee.

In some instances proper family and estate planning, beyond normal annual gifting considerations, does call for a lifetime gift of an asset - particularly if the property is declining in value.  The gift tax rules are different than a decedent step-up in basis rules.  When property which has gone down in value is the subject of a gift, the donee will take the date of gift value as his basis.  This is compared to a gift where the property has gone up in value in which the donee must take the donor's cost basis as his cost basis for tax purposes.  Generally the best plan for property which is declining in value is for the owner to sell it before death so that he can enjoy the full tax benefit of the capital loss.  This unusual rule may require special planning when some assets have decreased in value for a wealthy, but failing, individual who has a mix of assets with varying amounts of unrealized gain and loss.

Family members must also be aware of Code Section 691(a)(1) IRD rules which often come as a surprise to individuals inheriting property.  There are special tax rules applicable to items of income producing property received by a beneficiary known as "Income With Respect To A Decedent" or "IRD".

For the most part, property inherited by a beneficiary is not includable as taxable income on a beneficiary's tax return (Form 1040) e.g., cash, securities, mutual funds.  Items of IRD, however, must be included in the beneficiary's taxable income although the taxpayer may be entitled to an IRD deduction on Form 1040.

What is IRD?  IRD is income which the decedent (the person from whom you inherit the property) would have taken into taxable income on his income tax return except that death interceded.  The most common IRD item is a decedent's last paycheck received after death.  It would normally have been included in the decedent's income on his income tax return; however, since the decedent's tax year closed as of the date of death, it was not included.  As an item of IRD the payroll check is taxed as income to whoever receives the funds (the decedent's estate or an heir).  Not only are paychecks subject to this rule, but any employer compensation related benefits paid after death are considered IRD.  This includes accrued vacation pay and voluntary employer benefit payments which will be subject to IRD reporting on the recipient's tax return.  Other common IRD items include pension benefits and amounts in decedent's individual retirement accounts (IRAs) at death as well as the decedent's share of partnership income.

If you receive specific IRD items, the income is to be included in your taxable income on Form 1040 in the year the income was paid whether or not the distribution of income was actually made from the estate.  This is true for those beneficiaries who are income beneficiaries under the will, by contract, or under local law.  A common example is an inherited IRA or 401(k) which is received as cash by a beneficiary.  Decedent's deferred employee compensation which the decedent elected to defer under an employer's deferred compensation plan is also IRD.  Shares of stock in the employer corporation that had been payable to the decedent as a result of his exercise of compensatory employer stock options also fall under the IRD rule.  So are options vesting at the decedent's death. 

Here is a list of common IRD items which must be reported on an income tax return - either Form 1040 or Form 1041 (estate income tax return).

• Decedent's employer compensation related benefits paid after death.
• Decedent's individual Retirement Accounts (IRAs).
• Company or government retirement plans which have yet to be subject to income tax such as 401(k)s and 403(b)s - any qualified retirement plan which is liquidated.
• Annuity contact payments to beneficiaries in excess of the decedent's cost basis.
• Certificate of Deposit interest.
• U. S. Treasury Bond interest.
• Generally life insurance proceeds are not taxable to the recipient.  In the normal case life insurance proceeds are paid under third party (institutional) life insurance policies which, by operation of Code Section 101(a), are not taxable income to the beneficiary.  On the other hand, if it is the employer corporation which is paying a death benefit to the employee's estate or designated beneficiary then the proceeds are considered deferred compensation of the decedent and IRD.  The question is:  Who is paying the death benefit?  Life insurance company proceeds are exempt from income taxation.  Employer death benefit proceeds are deferred compensation IRD income.
• Payments on accounts receivable.
• Payments on installment agreements.

A possible IRD tax deduction exists.  Although IRD must be included on the income tax return of the income beneficiary, an income tax deduction may come along with it.  This deduction is allowed (as an itemized deduction on the recipient's Schedule A, Form 1040) to lessen the "double tax" impact caused by having the IRD item subject to decedent's estate tax as well as recipient's income tax.  The computation is complex but essentially means that the recipient beneficiary will have a deduction for estate taxes paid by the estate on the value of the asset includable in the taxable estate of the decedent.  Basically it amounts to a pro rata deduction for the amount of estate tax paid by the decedent's estate on the very same IRD asset - a percentage of the estate tax paid becomes a deduction for IRD income recognized by the recipient beneficiary. 

One of the most difficult tasks faced by an executor of a sizable estate is the complexity in planning distributions from the estate to the beneficiaries.  Obviously there are immediate needs and legitimate demands of beneficiaries; but there are a plethora of complex rules, which, to the uninitiated, may defy common sense.  Here are some of the basic planning strategies and objectives:

1. Splitting of the estate's IRD assets amongst the largest possible number of estate beneficiaries with the view to having the income taxed at lower marginal rates than if paid by the estate itself or if distrtibuted in larger sums to fewer beneficiaries.
2. Selection of a tax year for the estate (non calendar year) so as to defer recognition of income tax to beneficiaries.  With proper planning recognition of income on IRD items in the fiscal (and different) taxable year of the estate will provide the estate income tax return (Form 1041) with a "distributable net income" deduction for that year while the reporting of IRD taxable income will not be required by the beneficiaries until a later time.  Tax deferral is the result.
3. In some cases there may be an advantage in having a particular beneficiary report capital gains realized by the estate.  He may be in a position to offset the gains realized by the estate.  He may be in a position to offset the gains by carry forward losses or he may be in a lower income tax bracket than other beneficiaries. 

An individual who is receiving an inheritance should be aware that there can be a heavy income tax burden with property inherited from a decedent.  This is an important area often overlooked when families are addressing final affairs.  The executor should retain the services of an income tax professional to minimize and defer income tax obligations and to maximize the transfer of wealth from one generation to another.