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Taxes in Life and Death

It's been said that two things in life are certain: death and taxes. Ironically, tax considerations do not necessarily end with a person's death. They can continue for a number of years.

How are federal income taxes handled when someone dies? The last tax year of a deceased individual—called “the decedent” by tax practitioners—ends on the date of his or her death. The decedent's personal representative must file the final return. Assuming the decedent used the cash method of accounting (as most individuals do), only income that was actually received before death is included in the return.

This means that income the decedent was entitled to, but had not received by the date of death, is not reported. Such income is called “income in respect of a decedent,” or IRD for short. Special rules determine who must pay tax on this type of income. A person taxed on income in respect of a decedent may be entitled to related deductions, as well as a deduction for any estate tax generated by IRD.

Who reports the IRD? The income is taxed to either (1) the estate if the estate receives the right to it, (2) the beneficiary, if the right is passed directly to the beneficiary or (3) any person to whom the estate distributes the right to receive IRD.

Example 1. John was entitled to five installments of salary when he died. His estate receives two installments and distributed the right to receive the remaining three installments to John's daughter, Melissa. The unpaid salary is IRD. John's estate is taxed on two, while Melissa must pay tax on the remaining three installments.

Example 2. Edward owns Series EE U.S. Savings Bonds with his wife, Jan, as co-owner. The interest earned by the bonds is taxable when the bonds are redeemed. After Edward dies, the untaxed interest constitutes IRD. As a result, Jan is taxed on that IRD when the bonds are cashed in.

Other examples of IRD items are deferred compensation, pension income, payments from an IRA (individual retirement account), income from exercise of employment-related stock options, insurance renewal commissions, proceeds from a sale of property, partnership income, accrued interest on other bonds and savings certificates, back payments of alimony, accrued royalties and installment obligation payments.

What are deductions in respect of a decedent? This is the flip side of IRD. The list includes certain items (e.g., business and income-producing expenses, taxes and interest) that the decedent was liable for but did not pay before death. These items are deductible by the person who is taxed on the IRD when that person pays them.

How about deductions for federal estate tax? IRD items generally are included in a decedent's estate. However, in many cases, these items will be sheltered from estate tax by the unlimited marital deduction, the unified estate and gift-tax credit, or both.

In the event that IRD is subject to both income and estate tax, the person subject to income tax on the IRD can claim a special deduction for the estate tax that is generated by it.

With proper planning, you may be able to avoid tax on IRD. However, this is an extremely complex area of the tax law. It is recommended that you obtain professional advice concerning your family's situation.

 

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