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September 2004 Avoiding the IRD trap in estate planning IRD imposes unnecessary taxes on heirs, but it can be avoided with proper planning The Tax Code is continuously spawning acronyms that become part of popular jargon. “IRA” is in everybody’s vocabulary, and, unfortunately, “AMT” (Alternative Minimum Tax) is becoming all too familiar to more taxpayers every year. The new kid on the block, lingo-wise, is “IRD”: income in respect of a decedent. As the enormous transfer of wealth from Tom Brokaw’s “Greatest Generation” to the Baby Boom generation accelerates, tax professionals will likely spend more and more time educating their clients about the perils of IRD. IRD is not a term that is discussed in polite company. It refers to assets that pass from a decedent to his or her heirs without the normal “step up” in basis to fair market value that eliminates income taxes to the heirs. Normal situation. As a general rule, the Tax Code allows heirs to treat any inherited asset as revalued to full market value, using a valuation as of the date of death, as illustrated here: Example: Uncle Art bought stock 30 years ago at $10 per share. On the day he died, the stock closed at $100 per share. If you inherit some of those shares from Uncle Art, your tax cost is $100 per share. If you sell the stock a few months later at $102 per share, you have a two-dollar capital gain. As an added advantage, the two-dollar gain is taxed at favorable long-term capital gain rates, even though your ownership period was less than the requisite 12 months. Situations vulnerable to IRD One occurrence where the IRD can strike is upon the inheritance of IRAs and other qualified retirement plans. In such cases, the inherited asset is taxed to the beneficiary as though he were the original owner, i.e., without the stepped-up basis. Another IRD target is an annuity. Many retirees hold variable or fixed-rate annuities, but they often do not draw on them because they have learned that extractions cause income reporting and taxation. However, when those annuities pass to their heirs, the deferred income becomes fully taxable. Other less common IRD examples include the inheritance and sale of U.S. savings bonds (in which the deferred income is taxable only when the bond is cashed-in or matures, whether by the original owner or an heir), and existing installment sales, typically involving dispositions of real estate or closely held businesses or stock. Here’s an example of the latter: Example: Fred, a 70-year-old retiree, sells a rental building in return for a 20-year note and reports the gain under the installment method. Based on his depreciated cost in the building, principal collections on the note are 82% gain and 18% tax-free return of cost. If Fred passes away during the 20-year term of this note, his heirs must continue to report the collections as 82% taxable for the duration of the payments. The fact that IRD assets move to a beneficiary accompanied by a deferred income tax liability is not a total disaster; after all, inheriting a $10,000 IRA is good news, even if we incur 30% or $3,000 of income taxes when it is paid to us. The issue has to do with “tax inefficiencies” associated with the transfer of IRD property. Often, with a bit of planning, the tax to the heirs can be minimized and, in some cases, avoided altogether. The deathbed sale trap Assets that normally receive a step-up in tax cost when passing through an estate can be converted into the IRD problem if they become the subject of an ill-advised installment sale. Real estate, for example, that could be sold tax-free in a post-estate disposition can become taxable to the heirs if a pre-death installment sale is created. Example: Harry’s health is deteriorating. Wishing to get his affairs in order, he sells his commercial rental building for $400,000, on a 15-year installment note. His depreciated cost is $50,000. A year after the sale, Harry passes away, and Harry Jr. steps into his dad’s tax position on the installment sale, continuing to pay the capital gain tax as the payments are received over the remaining 14-year duration. Had Harry Sr. held onto the building and allowed Harry Jr. to sell the building after Harry Sr.’s death, it could have been sold free of income tax because of the step-up in basis rule. Charitable bequests Many individuals will spell out specific bequests to charity in their will or testamentary trust. For example, you might instruct that specific bequests of $20,000 each are to be made to three charities, with the balance of your estate to be divided equally among your children. This can be very tax-inefficient if part of the residual estate passing to the children includes IRD property, such as IRAs or annuities. The charities, which are tax-exempt entities, each receive a check for $20,000 that would be income tax-free to any heir, while the children receive retirement plans and annuities subject to income tax. The obvious strategy, of course, is to carve off the IRD assets to satisfy your charitable bequests. Rather than having a clause within the will that transfers $20,000 to each of the three charities, simply take an IRA or annuity account, segregate it to the desired value, and make the charity the beneficiary rather than your children. When the charity ultimately cashes in the IRA or annuity, it is a tax-free transaction because of its exempt status, and more of the assets passing to your children are free of income tax. This strategy can be particularly important for wealthier individuals who face exposure to estate tax. In that case, IRD assets face a double hit: First they are subjected to the estate tax, and then they face a potential income tax when cashed in or sold by the beneficiaries. When the 45% estate tax is combined with a typical 30% income tax, the sequential imposition of double taxation can leave the heirs with less than 40¢ on the dollar. Particularly in those situations, the direction of IRD assets toward charitable entities is advisable. Inflation protection option The U.S. Treasury recently announced an expansion of its Treasury Inflation-Protected Securities (TIPS). Previously, they have been available only in a 10-year term, but now five- and 20-year maturities are being offered. These securities are unique. They pay a fixed interest rate, the principal is adjusted every six months for inflation, and the interest rate is applied to that increasing principal balance. While TIPS are unique in their ability to ratchet-up in value if inflation kicks in, they do have harsh tax consequences. Both the direct interest payment and the inflation growth are currently taxable. That suggests that investors may want to concentrate any TIPS investments within their tax-deferred retirement plans. Alternatively, the Treasury also offers “I bonds” that similarly earn both a regular interest rate and inflation-adjusted principal, but they are taxed only upon redemption, like other savings bonds. Questions? If you read this article closely, you now have a better understanding of the potential sting of IRD. Call your Schmidt Westergard & Company tax professional for an analysis of your estate and how to spare your heirs needless taxation. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |
