Minimize Income Tax Issues With Proper Estate Planning

Estate Planner Sept-Oct 2000

To assure that your estate plan will work as you intend, don’t overlook income tax issues your loved ones may face after you are gone. A problematic issue to consider is that some assets you own at death may constitute deferred income — also known as income in respect of a decedent (IRD). The most obvious examples of IRD are regular individual retirement accounts (IRAs) and retirement plans. If you are a doctor, lawyer, accountant or own an unincorporated business, you may have significant IRD in the form of uncollected fees or accounts receivables. These types of assets will remain subject to income tax after your death, either by your estate or your beneficiary.

Allocating assets among your beneficiaries to reduce income tax is a key part of a smart estate plan. You may already be familiar with the advantages of deferring income tax during your lifetime with assets such as traditional IRAs. An important goal of estate planning is to allow your family to continue that deferral after you are gone. Let’s take a closer look at how IRD can affect your estate planning.

Not All Assets Are Treated Equally 

When deciding how to distribute your assets upon your death, keep in mind that not all assets are treated equally.

For example, suppose you leave your house to your son and leave your interest in a deferred compensation plan to your daughter. Even if both assets have the same market value at your death, your daughter may receive much less because the assets received are subject to income tax. Your son will receive a step-up in basis on the house as of the date of your death. When he sells the house, he will not owe capital gains tax. IRD assets are not entitled to a step-up in basis.

If you have sufficient assets in your estate, you’ll want to fund the trust that qualifies for the marital deduction with IRD assets rather than with your credit shelter trust. Doing so doesn’t waste credit shelter funds on income tax. Use other assets for the credit shelter trust. In addition, paying income tax with the marital share may reduce the estate tax ultimately paid by the surviving spouse at death.

Benefits under a deferred compensation plan that you have not yet paid income tax on is another type of IRD. Roth IRAs are not IRD because you fund them with after-tax dollars and they continue to grow income tax free.

Another example of assets that are not treated equally are IRAs. For example, if you leave a regular IRA to one child and a Roth IRA with the same value to another child, whoever receives the Roth IRA will realize a larger payoff. Why? Because a regular IRA has a built-in income tax liability and the Roth IRA is income tax free. In addition, if your child continues to hold the Roth IRA, the growth in its value will also be income tax free.

In contrast, income tax can be deferred on a regular IRA if it continues to be held, but any increase in the IRA’s value will also be subject to income tax. (An additional advantage of receiving a Roth IRA is that distributions are not required to begin at age 701/2, unlike a regular IRA.)

The disadvantages of receiving IRD assets are offset somewhat because your beneficiaries can receive an income-tax deduction based on the amount of federal estate tax paid on the IRD asset. Be careful to fairly apportion this deduction among your beneficiaries. For example, if you leave $1 million of IRD assets to your daughter through a beneficiary designation and $2 million of non-IRD assets to your son through your will, your son may receive a $1 million estate tax bill, while your daughter may be able to shelter the income and receive the deduction.

Play by the Rules

An important part of planning for IRD assets is to ensure that your beneficiaries can defer payment of income tax as long as possible. When planning your estate, keep in mind these general rules regarding IRD:

When giving a specific amount, be sure enough non-IRD assets are available to fund it. Otherwise, income tax may be triggered. For example, if your will provides that you leave $10,000 to your friend and the bequest is satisfied with an IRD asset, your estate could owe income tax.

Many estate plans use a formula to provide that your applicable exclusion amount (currently $675,000) will pass to one trust and the balance will pass to a marital trust for your spouse. The use of these formulas can sometimes trigger IRD on the funding of the trust. To avoid triggering IRD, provide that a specific fraction of your assets be used to fund the trusts rather than a specific amount.

Avoid naming your estate — rather than specific persons — as beneficiary of IRD. If your estate receives the asset first and it passes to a beneficiary, then income tax may become due immediately.

Lessen the Impact of Income Tax On Your Beneficiaries

Planning for estate tax can be difficult enough. Factoring in income tax significantly increases planning complexity. By learning how to allocate IRD affected assets, you can greatly lessen the impact of income tax on your beneficiaries.