IRD Income and the Frequently Overlooked Estate Tax Deduction
When a client comes in with a 1099R or Schedule K-1 with income from an inherited individual retirement account (IRA), ask two very important questions:
(1) Was there a Form 706 filed for the estate?
(2) If so, was there a tax liability on the 706?
If the answer to both questions is yes, then your client is eligible for a Tier 1 miscellaneous (not subject to the 2% reduction of adjusted gross income [AGI) itemized deduction.
Background - IRD is included in the decedent’s gross estate AND is subject to income tax. To make up for this inequity, a deduction for estate tax is allowed to the ultimate recipient of the income on the recipient’s return for the same year in which the income is included. If the recipient is an individual, it is claimed as a miscellaneous itemized deduction—one that is not subject to the 2%-of-AGI limitation—on the individual’s Schedule A for Form 1040. If the estate receives the income, the deduction is claimed on Form 1041. (IRC § 691(c)(1)(A);Reg § 1.691(c)-1(a))
Amount Deductible - The amount of estate tax that is deductible is the part representing the net value of all items in the estate that are IRD.
Example A: Sergei, a lawyer, was a cash-basis taxpayer when he died two years ago. At the time, he was entitled to $12,000 from clients in payment for services. He had also accrued $8,000 in bond interest at the time of his death. He owed $5,000 in expenses for which his estate became liable. The income and expenses were reported on Sergei’s estate tax return. After credits, the estate owed $9,460 in tax. The net value of items included as IRD is $15,000 ($20,000 income less $5,000 expense). The estate tax determined without including the $15,000 is $4,840. The estate tax that qualifies for the deduction is $4,620 ($9,460 minus $4,840).
Example B: Assume Diane inherited Sergei’s estate (Example A). She collected the owed $12,000 from clients this year and will include that amount as income on her current year return. She itemizes deductions and will claim a miscellaneous deduction of $2,772, figured as follows: $12,000/$20,000 x $4,620 = $2,772.
Caution – Again, many sources report this as the most overlooked deduction in taxes. The primary reason for this is there is no Internal Revenue Service (IRS) form associated with the 706 providing the beneficiaries with the information needed to determine the deduction. Therefore, it is the responsibility of the practitioner to recognize the potential for this deduction when a taxpayer has inherited taxable income.