Who can accurately predict what the income tax and estate tax rates and thresholds will be in the year 2013? Nobody. In 2010, Congress extended the Bush income tax cuts and enacted a relatively low 35 percent estate tax rate for 2011 and 2012, but few expect a repeat of that scenario for 2013.
If nothing is done, tax rates on many sources of income will increase in 2013. Dividends are slated to experience the steepest tax rate increase, from a maximum federal rate of just 15 percent in 2012, to a new maximum federal rate of 43.4 percent in 2013 (See “Something Old, Something New,” p. 42). Another source of income that could be hit particularly hard in 2013 is income in respect of a decedent (IRD), particularly IRD that’s included in estates that are subject to the federal estate tax. Such income consists of payments received after death by an estate or by a beneficiary that would have been taxable income had the decedent received them before he died.1 Not only could such income be subject to new federal income tax rates as high as 43.4 percent, but also, it could be subject to a higher estate tax rate: up to 55 percent in 2013, compared to just 35 percent in 2012. When hit with a double whammy of estate taxes and income taxes, the combined federal tax rate on IRD of 58 percent in 2012 could climb to over 79 percent in 2013. And yes: State income taxes are extra.
Estate planners and their clients should understand the rules that apply to IRD and the planning strategies that can mitigate the tax cost. The most likely source of IRD is a distribution from an inherited retirement account, such as an individual retirement account or a 401(k) plan. Strategies that can reduce the tax bite include lifetime Roth IRA conversions and charitable bequests of IRD.
There are several significant changes scheduled for the estate tax in 2013. The biggest impact on the largest multi-million dollar estates is the scheduled increase of the federal estate tax rate from a flat 35 percent in 2012 to rates that range between 41 percent and 55 percent in 2013.2 Part of this rate will include the return of the state death tax credit.3
Of considerable importance to smaller estates is the threshold at which the federal estate tax will be imposed. That’s scheduled to plummet from $5.12 million to just $1 million.4 This will significantly increase the number of estate tax returns that will have to be filed.5
Next year could prove to be the perfect storm for higher income taxpayers. First, the Bush tax cuts are scheduled to expire at the end of 2012, thereby increasing the highest marginal income tax rate from 35 percent to 39.6 percent. Second, 2013 marks the first year of new surtaxes to pay for national health care, assuming that the U.S. Supreme Court confirms that the health care legislation is constitutional. Taxpayers with income over $200,000 ($250,000 on a joint return) will pay a 3.8 percent surtax on most investment income (including long-term capital gains) and a 0.9 percent surtax on income earned from employment.6 The principal source of income that will be exempt from the surtax will be pension and retirement plan distributions, including distributions from IRAs. Thus, as “Something Old, Something New” illustrates, the highest marginal income tax rates for most sources of investment income is scheduled to climb from 35 percent to 43.4 percent, though retirement plan distributions will only be subject to a maximum rate of 39.6 percent, because they’ll be exempt from the health care surtax.
Implications for IRD
Most inheritances are exempt from income tax, and most inherited property receives a stepped-up income tax basis. The notable exception is IRD.
IRD usually retains its original character. For example, inherited savings bond interest is taxed as interest income and inherited long-term capital gain income (generated, for example, by receipt of an installment payment after death) is taxed as a long-term capital gain. Generally, every distribution that a person receives from an inherited IRA or a qualified retirement plan (QRP) account is fully taxable as ordinary income.7
The IRA or QRP administrator will usually issue a Form 1099-R directly to the individual who received the distribution, and that individual will be liable for the income tax rather than the probate estate.8 A beneficiary won’t be subject to the 10 percent early distribution penalty, even if she’s under age 591/2 or the account owner died before attaining age 591/2.9 The beneficiary could, however, be subject to the 50 percent penalty tax in any year that the distributions are less than the applicable minimum required distribution for the year, under the rules that apply to inherited accounts.10
IRC Section 691(c)
The combination of a 55 percent estate tax and a 43.4 percent income tax could produce a confiscatory tax rate, but Congress afforded relief in IRC Section 691(c).A recipient of IRD can claim an itemized income tax deduction for the federal estate tax attributable to the IRD. This is the principal source of relief that’s available. The Internal Revenue Service and the courts have rejected other attempts to mitigate the estate tax burden caused by the deferred income taxes inflating the value of the retirement assets that are reported on the estate tax return.11
A beneficiary is entitled to deduct the federal estate tax attributable to IRD in the same taxable year that the IRD is included in the beneficiary’s income.12 The Section 691(c) deduction is based on the highest marginal estate tax rate imposed on the estate, rather than an average estate tax rate.13 The deduction is reduced by any estate tax credits—most notably the state tax credit.14 The net amount of IRD is also reduced by any expenses that are directly associated with the IRD—deductions in respect of a decedent.15
If the beneficiary is an individual, the Section 691(c) deduction for the federal estate tax is taken as an itemized deduction.16 It’s not subject to the 2 percent of adjusted gross income limitation to which most miscellaneous deductions are subject.17 Since it’s an itemized deduction, beneficiaries who claim the standard deduction won’t receive any tax benefit from the Section 691(c) IRD estate tax deduction. An estate or trust that receives IRD can claim the IRD estate tax deduction,18 unless the IRD is required to be distributed to a beneficiary, in which case the deduction passes through to the beneficiary.19 Also, special rules for computing the Section 691(c) deduction apply to inherited long-term capital gains,20 IRD included in multiple estates21 and lump sum distributions from an IRC Section 401(a) QRP, when the beneficiary elects the forward-averaging tax.22
2012 and 2013
“Example: 2012,” and “Example: 2013” illustrate the dramatic impact that the pending tax increases will have on an inherited retirement plan 2012.
Whereas “Example: 2012” demonstrates that in 2012, the highest tax rate generated by the combination of estate and income taxes is 57.75 percent, “Example: 2013” illustrates that the rate will climb to 77.6 percent. And this rate understates the actual highest potential tax rate. First, it doesn’t include the return of the “3 percent haircut” (that is, a taxpayer will lose 3 percent of itemized deductions once taxable income exceeds roughly $170,000). Second, although retirement plan distributions are exempt from the 3.8 percent surtax for national health care, other sources of IRD would likely be subject to that additional tax. Third, the computations assume there’s no generation skipping transfer tax. And fourth, state income taxes are extra.
Estate planners strive to reduce the size of a taxable estate through a variety of techniques. For example, they encourage clients to make lifetime gifts to get appreciating assets out of their estates. For those assets that will be included in a taxable estate, estate planners encourage the use of techniques that can produce a valuation discount. Both of these techniques are virtually impossible with retirement assets.
Retirement accounts are some of the toughest assets to plan for. Your client can’t make a lifetime gift of her retirement account.23 She can’t put her retirement account into a family limited partnership and get a valuation discount. Although courts have allowed valuation discounts for IRD of unassignable lottery payments24 and for the capital gains component of appreciated closely held stock,25 they’ve rejected attempts to claim valuation discounts for the income tax component of a retirement account.26 Consequently, instead of receiving a discounted value on a federal estate tax return, a retirement account receives an inflated value, because the valuation includes the deferred income taxes. Retirement assets stand out on the Form 706 federal estate tax return like a big zit. The one source of tax relief is IRC Section 691(c).
For those estates that are large enough to be subject to the estate tax, the double whammy of estate taxes and income taxes could consume roughly 80 percent of the value of IRD assets in 2013. There are several strategies that can reduce the tax bite. For those whose wealth is near the estate tax threshold, one pre-mortem strategy is to do a Roth IRA conversion. For those with taxable estates of any size, another strategy is to make a charitable bequest of IRD assets.
Roth IRA Conversion
A Roth IRA conversion is a transfer of assets from a traditional IRA or some other QRP account into a Roth IRA. It triggers an income tax liability. The conversion is treated as a taxable distribution from the traditional account, followed by a non-deductible contribution to a Roth IRA.27
Whereas estate planners discourage clients from an early liquidation of a retirement account, because that ends the account’s tax-deferral advantages, the beauty of a Roth IRA conversion is that it moves pre-tax assets from one type of tax-exempt trust (for example, a traditional IRA) into after-tax assets in another tax-exempt trust (the Roth IRA). The estate tax advantage of a Roth IRA conversion is that the size of the estate is deflated by removing the inflated pre-tax retirement assets from the estate. By comparison, a person with a taxable estate will be paying estate tax on the deferred income taxes contained in a traditional retirement account.
A Roth IRA conversion may be the best pre-mortem strategy for retirement assets, even for the largest taxable estates.28It’s particularly advantageous for an estate whose size is barely over the threshold that would trigger an estate tax liability.
Example: Assume that Grandma (age 87) is about to enter the hospital in 2012 with a serious medical condition and that she has a taxable estate of $5.22 million, which consists of $1 million in a traditional IRA and $4.22 million of cash, stock and real estate. Grandma can completely avoid federal estate tax liability by doing a Roth IRA conversion of $300,000 from her IRA. That will trigger a $100,000 income tax liability and bring her taxable estate down to the $5.12 million level that eliminates the federal estate tax in 2012. If she dies, her family will inherit a $700,000 taxable IRA, a $300,000 tax-exempt Roth IRA and $4.12 million of cash, stock and real estate. Distributions received from the $700,000 inherited traditional IRA are taxable IRD,29 but distributions from the converted $300,000 Roth IRA will be exempt from income taxation. Had she not done the Roth IRA conversion, the estate would have paid a 35 percent federal estate tax on the $100,000 of deferred income taxes. If Grandma overcomes the medical condition, she has the option to reverse the Roth IRA conversion anytime before her income tax return is due in the following year (that is, a recharacterization).
If the scheduled tax rates for 2013 actually come to pass and the IRD in taxable estates is subject to a near 80 percent tax rate, then even the most uncharitable individual will be making sizeable charitable bequests. That person will be giving nearly 80 percent of the IRD assets to the government—an eligible charitable recipient—but as taxes, rather than as a gift. Individuals can, instead, devote 100 percent of these assets to a specific charitable cause that they may care more about.30
As a general rule, it’s best to have the IRA or QRP assets transferred directly to the charity or charitable remainder trust after the decedent’s death. This is usually best accomplished by naming the charity as a successor beneficiary on the retirement plan beneficiary designation forms. This will keep the assets off of the estate’s income tax return (Form 1041). This arrangement avoids the legal problems that can occur when retirement assets are payable to an estate or trust that will then make a charitable bequest.31
A flexible post-mortem strategy for retirement assets in a taxable estate is a disclaimer to a charity. The primary beneficiary of the retirement account can disclaim some or all of the assets to a charity that was named as a contingent beneficiary. A good charitable candidate is a donor advised fund in which the person who makes the disclaimer can later make charitable grant recommendations.32 By comparison, an attempt to disclaim to a private foundation poses tax problems.33
The double whammy of higher estate tax rates and higher income tax rates could hit IRD particularly hard in 2013. Congress provided tax relief in December 2010 and may do so again. Estate planners will continue to be alert to the changes and will recommend the best strategies for whatever rules and incentives that Congress prescribes.
1. Internal Revenue Code Section 691. For example, an inherited covenant-not-to-compete payment is income in respect of a decedent (IRD). Coleman v. Commissioner, T.C. Memo. 2004-166.
2. IRC 2001(c).
3. IRC Section 2011.
4. Supra note 2.
5. Only 9,176 of the federal estate tax returns filed in the year 2007 reported over $5 million of assets. Brian Raub and Joseph Newcomb, â€œFederal Estate Tax Returns Filed For 2007 Decedents,â€ IRS Statistics of Income Bulletin (Summer 2011), pps. 182-213, at figure H, p. 190. By comparison, there were 108,071 returns filed in 2001 when the threshold was just $675,000. Ibid. at p. 183. See also Martha Britton Eller, â€œWhich Estates Are Affected by the Federal Estate Tax?: An Examination of the Filing Population for Year-of-Death 2001,â€ IRS Statistics of Income Bulletin (Summer 2005), at pps. 1-18. (Updated article reflects data released in October 2007; see www.irs.gov/pub/irssoi/01esyod.pdf).
6 IRC Section 1411 (as modified by IRC Section 1402 of The Health Care and Education Reconciliation Act of 2010 (P.L. 111-152) (3.8 percent investment income surtax)) and IRC Section 9015 (as modified by IRC Section 10906 of The Patient Protection and Affordable Care Act, P.L. 111-148 (0.9 percent compensation surtax))
7. IRC Sections 402(a) and 72 for Section 401(a) qualified retirement plans (QRPs); IRC Sections 408(d) and 72 for individual retirement accounts. See Cutler v. Commâ€™r, T.C. Memo. 2007-348 and Revenue Ruling 92-47, 1992-1 C.B. 198 for inherited IRAs and see Rev. Rul. 2005-30, 2005-1 I.R.B. 1015 for inherited annuity payments. Exceptions apply if: (1) the distribution includes a return of non-deductible contributions (tax-free to the recipient under IRC Sec-
tions 402(a) and 72(b)); (2) a portion of the distribution is rolled over into another IRA or QRP, IRC Section 402(c); (3) the distribution is a lump-sum distribution of the entire balance in an account of an IRC Section 401(a) QRP that qualifies for the old 10-year forward-averaging tax (IRS Form 4972); or (5) the distribution is from an inherited Roth IRA, Roth 401(k) or Roth 403(b) that qualified for exclusion from taxable income.
8. IRC Section 691(a)(2); Treasury Regulations Sections 1.691(a)-2(a)(2) and 1.691(a)-2(b); Rev. Rul. 92-47, 1992-1 C.B. 198 (Holding 1).
9. IRC Section 72(t)(2)(A)(ii) exempts distributions from the 10 percent early distribution penalty tax if theyâ€™re made to the estate of the account owner or to a beneficiary after the account ownerâ€™s death.
10. IRC Sections 4974 and 401(a)(9)(B); Treas. Regs. Section 54.4974-1.
11. See infra note 26.Â
12. IRC Section 691(c)(1)(A); Treas. Regs. Section 1.691(c)-1(a); Rev. Rul. 92-47, 1992-1 C.B. 198 (Holding 2).Â Even late alimony payments paid after death will qualify for the Section 691(c) deduction. Kitch v. Commâ€™r, 103 F. 3d 104 (10th Cir. 1996), affâ€™gÂ 104 T.C. 1 (1994).
13. The estate tax attributable to the IRD is computed by comparing the amount of estate tax that would have been paid if the estate had no IRD, with the actual amount of estate tax that the estate paid with the IRD. IRC Section 691(c)(2)(C).
14. IRC Section 691(c)(2)(A). The state tax credit is contained in IRC Section 2011. It was eliminated in 2007, but is scheduled to return in 2013 after the Bush tax cuts expire.
15. IRC Sections 691(b) and (c)(2)(B). An example is an attorney who died before collecting a fee (the IRD) and who had incurred unpaid business expenses in connection with the fee (the deduction in respect of a decedent). Treas. Regs. Section 1.691(c)-1(d), Example 1. Such reductions rarely apply to distributions from IRAs or QRPs.
16. Rev. Rul. 78-203, 1978-1 C.B. 199.
17. IRC Section 67(b)(7). The deduction is claimed on the line of Schedule A that follows the 2 percent limitation (other miscellaneous deductions).
18. Treas. Regs. Section. 1.691(c)-2(a)(3).
19. IRC Section 691(c)(1)(B); Treas. Regs. Section 1.691(c)-2(a)(1) and (2).
20. If the IRD consists of a long-term capital gain, then the IRD deduction is applied to reduce the long-term capital gain, which might be taxed at a rate of only 15 percent (20 percent or 23.4 percent in the year 2013), rather than a deduction against ordinary income, for which the taxpayer might obtain a benefit at a higher marginal tax rate. IRC Section 691(c)(4).
21. For example, a grandchild inherits IRD that had been taxed in both her grandfatherâ€™s and her fatherâ€™s estates, in which case the grandchild is permitted to deduct the estate tax attributable to both estates. Treas. Regs. Section 1.691(c)-1(b).Â
22. IRC Section 691(c)(5). The rules are explained in the instructions to Internal Revenue Service Form 4972.
23. Any distribution to any individual from a retirement account usually generates taxable income to the participant or IRA owner. The one exception is an eligible charitable IRA rollover gift to a charity thatâ€™s made directly from an IRA. (IRC Section 408(d)(8)(B)â€”a temporarily â€œextenderâ€ law that expired at the end of 2011, but will likely be re-extended into 2012). Even a pledge of a retirement account as collateral for a loan generally triggers taxable income to the IRA account owner or to the QRP participant. IRC Sections 408(e)(4) and 72(p)(1)(B).
24. Some courts have permitted discount valuations for unassignable IRD lottery payments that were included in a decedentâ€™s estate. Estate of Gribauskas v. Commâ€™r, 342 F.3d 85 (2d Cir. 2003) and Shackleford v. United States,Â 262 F.3d 1028 (9th Cir. 2001).
25. A valuation discount was permitted for the built-in capital gains component of closely held C corporation stock. Estate of Davis v. Commâ€™r, 110 T.C. 530 (1998) and Eisenberg v. Commâ€™r, 155 F.3d 50 (2d Cir. 1998).
26. No valuation discount for the deferred income tax component of a retirement account was permitted. Estate of Smith v. U.S., 391 F.3d 621, 626 (5th Cir. 2004); Estate of Doris F. Kahn v. Commâ€™r, 125 T.C. 227, 232 (2005). The estate canâ€™t deduct income taxes paid on IRD as an estate tax administrative expense. Technical Advice Memorandum 200444021 (June 21, 2001).
27. IRC Section 408A(d)(3)(A)(I) & (ii); Treas. Regs. Section 1.408A-4, Q&A-1(c) and Treas. Regs. Section 1.408A-4, Q&A-7.
28. See Steven A. Trytten, â€œAre IRAs and Charities the Perfect Match?â€ Trusts & Estates (September 2010) at p. 40. Computations in the article illustrate that making a Roth IRA conversion and then a leaving a stretch Roth IRA to a beneficiary can produce substantially greater wealth over 55 years than if a beneficiary inherited a traditional brokerage account. In that case, it could make sense to convert traditional IRA assets into Roth IRAs for beneficiaries and to make charitable bequests with non-IRA assets. If, however, Congress enacts proposed legislation to eliminate stretch IRAs, then the equation would likely tilt in favor of using taxable retirement accounts for charitable bequests. The 2012 Senate proposal to require almost all inherited retirement accounts to be liquidated in just five years can be found at Joint Committee on Taxation, Description of the Chairmanâ€™s Modification To the Proposals of the Highway Investment, Job Creation And Economic Growth Act of 2012, JCX-11-12, atÂ pp. 12-17 (Feb. 7, 2012).Â
29. Rev. Rul. 92-47, 1992-1 C.B. 198; Private Letter Ruling 200336020 (June 3, 2003).
30. Since charitable bequests qualify for both estate and income tax deductions, every dollar can be transferred to a charity free from any taxes. IRC Sections 2055 and 642. In addition, since charities are tax-exempt, they can apply all of the IRD toward an individualâ€™s charitable purposes.Â
31. The income tax problem is that the estate or trust will recognize taxable income when it receives the distribution from the retirement account, but it might not be able to claim an offsetting charitable income tax deduction under IRC Section 642(c) when it makes the distribution to the charity. See Christopher R. Hoyt, â€œTreacherous Waters,â€ Trusts & Estates (January 2009) at p. 15.
32. The IRS concluded that the advisory nature of a childâ€™s or grandchildâ€™s grant recommendations didnâ€™t pose a problem. See PLRs 200518012 (Dec. 17, 2004) (disclaimers by grandchildren) and 9532027 (May 12, 1995) (disclaimers by children).
33. A problem exists if a parent names a child as a beneficiary of an estate and through the childâ€™s disclaimer, the property passes to a private foundation (PF) in which the child is a director. The childâ€™s participation in the PFâ€™s selection of charitable grant recipients could prevent the disclaimer from being a qualified disclaimer. This is because the child would be typically involved in selecting the PFâ€™s ultimate charitable beneficiaries, which could violate the requirement that the interest in property passes â€œwithout any direction on the part of the person making the disclaimer.â€ Treas. Regs. Section 25.2518-2(d)(1) & (2); 25.2518-2(e)(1)(I).Â One solution to deal with this issue is for the PF to amend its bylaws so as to prohibit the child and the childâ€™s spouse from participating in the selection of grant recipients from amounts that are attributable to the disclaimed property. See PLRs 200649023 (Aug. 23, 2006), 9317039 (Feb. 2, 1993) and 9141017Â (July 10, 1991). This is a fairly clumsy solution that interferes with a parentâ€™s desire to allow children to be involved with a PF. A better option may be to have a child disclaim property to an advised fund of a community foundation, as described in the PLRs cited in the preceding endnote.