An 80% tax bracket? Beware the hidden tax trap of IRD - Estate Planning - income in respect of decedent

California CPA, Dec, 2003 by Christopher R. Jarvis, Michael B. Allmon

We know that there isn't an 80 percent income tax bracket (though none of us would be surprised if one emerged). However, there is a way for an asset to generate an 80 percent--or greater--tax liability.

The asset category is income in respect of decedent (IRD). This is an important issue as nearly all high-wealth clients face this potential tax cost and should be looking for advice to help their families avoid it. Also, a number of experts have written that CPAs and attorneys who avoid this issue in an estate plan may be violating the standard of care and subjecting themselves to professional liability.

What is IRD?

IRD is simply money people should have received and paid taxes on, but did not because they died before receiving the money. The most common types of IRD are unpaid commissions, bonuses and other receivables, as well as retirement plan (and IRA) balances.

The IRS' theory behind IRD is simple: There are two certainties--death and taxes--and even if you die, the tax bill doesn't go away. The government does not want deferred income, such as commissions and pension plan distributions, to pass to the heirs without someone first paying income tax on that money.

How Can IRD Generate an 80% Tax Liability?

When an individual passes away and there is an estate tax liability to calculate, the CPA or attorney will total all assets and liabilities. The potential income tax liability from the IRD is not part of that calculation. Therefore, the estate tax liability is based on the value of the IRD asset. If the estate (or the heirs) takes the entire distribution of the IRD asset, there will be both an estate tax and income tax liability.

Let's say a client passes away with an estate valued at $5 million. The largest single asset in the estate is a $2.5 million pension. The client also leaves $2 million worth of real estate and a $500,000 home. Since the client had a properly formed and funded living trust, the estate taxes totaled approximately $2 million.

Since the children don't want to sell the real estate in a short period of time, they take a withdrawal of $2 million to pay the estate taxes. This isn't a bad idea as they will still be left with $500,000 in the pension and $2.5 million in combined real estate, right? Wrong.

Next year, the income taxes on the $2 million withdrawal will be about $950,000. The first $500,000 can come from the remaining pension assets, but they will have to sell the home or mortgage the real estate to come up with the remaining $450,000 to pay the bill. Then, in the third year, they will have to mortgage the real estate for an additional $240,000 to pay the taxes on the $500,000 withdrawal of the pension. Of course, now the kids have to pay interest on the $690,000 outstanding loan.

So, from a $5 million estate, the heirs will pay $3.2 million in taxes and subject themselves to nearly $700,000 in debt.

When a client's estate can be decimated by 80 percent, how can we ignore the problem?

How Can We Help Our Clients?

While most advisers create estate plans to avoid probate and large estate taxes, many forget to address the estate/IRD problem. Some of the common strategies offered by professionals include charitable planning, stretch IRAs and capital transfer strategies.

Charitable Planning. Much of the literature on estate/IRD suggests that advisers should counsel clients to gift IRD assets to charity to avoid estate and income taxes. In our experience, charitable planning only works if the client has an interest in giving to a charity or there is a significant income tax or capital gains tax avoidance that accompanies the planning.

If you want your clients to give to charity just to avoid taxes, they have to be willing to leave their children significantly less. If you want to utilize charitable planning options for your clients, do so while they are alive so they can take advantage of the tax deductions.

Now, some advisers have touted that a client can "have his cake and eat it too" by leaving the IRD to a charitable foundation and have the children serve as executives of the charity. However, this use of a "quasi-charitable" entity for the exclusive benefit of reducing taxes with very little (or no) benefit to charity has been a major focus of recent IRS lawsuits, audits and attacks.

Stretch IRA: Penny-Wise & Pound-Foolish? Stretch IRAs are the most commonly discussed solution for estate/IRD. The concept is that you can reduce your minimum required distributions from a retirement plan or IRA by naming children as joint beneficiaries. By reducing minimum distributions, clients can reduce their income tax liability and allow the funds to continue to grow tax-deferred.

There are two keys to understand before recommending this to clients: First, even though the IRA withdrawals are deferred, the entire value of the retirement plan is included in the estate when determining the estate tax liability. There is no estate tax deferral and the estate taxes are still due within nine months of the date of death, so the "estate" part of the estate/IRD problem is not addressed.