While in a consultation recently, an executor brought up a discussion with a prior attorney. The executor was told that the estate was “too small” to worry about taxes. Although that was true for one tax, i.e. the Federal estate tax, there are actually multiple death taxes for executors to consider in an estate administration, most of which apply in more cases than the estate tax and are often overlooked by executors.
For example, every executor, trustee or administrator should consider “income in respect of a decedent” or “IRD”. This kind of income has its own tax rules and they may be complex, says Yahoo! Finance in a recent article simply titled “Income in Respect of a Decedent (IRD).”
Incidentally, if you were looking for information on the estate tax, here are the basics. https://www.galliganmanning.com/what-exactly-is-the-estate-tax/
Income in respect of a decedent is any income received after a person has died, but not included in their final tax return. When the executor begins working on a decedent’s personal finances, things could become challenging, especially if the person owned a business, had many bank and investment accounts, or if they were unorganized.
What kinds of funds are considered IRDs?
- Uncollected salary, wages, bonuses, commissions and vacation or sick pay.
- Stock options exercised
- Taxable distributions from retirement accounts
- Distributions from deferred compensation
- Bank account interest (very common one)
- Dividends and capital gains from investments
- Accounts receivable paid to a small business owned by the decedent (cash basis only)
As a side note, this should serve as a reminder of how important it is to create and update a detailed list of financial accounts, investments and income streams for executors to review in order to prevent possible losses and to correctly identify sources of income.
How is IRD taxed? IRD is income that would have been included in the decedent’s tax returns, if they were still living but wasn’t included in the final tax return. Where the IRD is reported depends upon who receives the income. If it is paid to the estate, it needs to be included on the fiduciary return. However, if IRD is paid directly to a beneficiary, then the beneficiary needs to include it in their own tax return.
If estate taxes are paid on the IRD, tax law does allow for an income tax deduction for estate taxes paid on the income. If the executor or beneficiaries missed the IRD, an estate planning attorney will be able to help amend tax returns to claim it.
Retirement accounts are also impacted by IRD. Required Minimum Distributions (RMDs) must be taken from IRA, 401(k) and similar accounts as owners age. The RMDs for the year a person passes are also included in their estate. The combination of estate taxes and income taxes on taxable retirement accounts can reduce the size of the estate, and therefore, inheritances. Tax law allows for the deduction of estate taxes related to amounts reported as IRD to reduce the impact of this “double taxation.”
The key here is to work diligently with your tax preparer in an estate or trust administration to identify, report and pay for IRD. Happily, estates have several costs which might be deductible to the IRD paid by the estate, such as funeral or administrative costs, meaning it is very possible no tax will be due even where there is substantial IRD.
In all events, if you are administering an estate you want to ensure IRD is addressed, and paid for if necessary. One of the most important aspects of estate administration is providing a sense of finality, knowing that the legal and financial steps are finished so you can focus on your family in a difficult time. Addressing the IRD ensures you don’t receive a letter from the IRS years later about unreported income.
Reference: Yahoo! Finance (Oct. 6, 2021) “Income in Respect of a Decedent (IRD)”