From the Archives: The IRC Section 691(c) Deduction
Examining this helpful income tax deduction for heirs and beneficiaries
In this series, “From the Archives,” I revisit popular videos and topics from my YouTube channel.
Intro and Video
While many assets get a step-up in basis at death under IRC Section 1014, there is a class of assets called income in respect of a decedent, or “IRD",” which is not eligible for this basis step-up. Instead, under IRC Section 691(a), IRD is generally taxable to the recipient. Taking a step back, IRD is generally income that is earned by the decedent during life, but which has not yet been subject to income tax prior to the decedent’s death.
The most frequent example of IRD is an interest in tax-deferred assets such as IRAs, qualified plans, and annuities.
As a bit of a policy lesson, gifts and inheritances generally are not subject to income tax in the hands of the recipient. IRD, however, is an obvious exception. Because the estate tax and applicable credit are applied to the fair market value of assets owned or deemed owned by the decedent at death, the step-up in basis usually prevents the same assets from being subject to both estate tax and income tax from a policy perspective. Where IRD is involved, does this mean the lack of a basis step-up causes double tax?
Slides
Analysis
While perhaps oversimplified, IRC Section 691(c) grants a deduction that generally prevents this double-tax. In other words, any estate tax that is attributable to IRD creates a deduction that can be claimed by the recipient of the IRD.
There is one big difference from the step-up in basis for appreciated assets. For the step-up, it does not matter whether or not estate tax is paid - the step-up is granted regardless. (Remember that assets having a basis higher than FMV as of the decedent’s date of death or alternate valuation date get a step-down in basis to estate tax value - reflecting an inability to preserve and transfer certain built-in losses to heirs and beneficiaries.)
But, for the 691(c) deduction, estate tax has to actually be paid as the ticket to entry for the deduction. The good news is that this deduction is usually calculated in a taxpayer-friendly manner. How?
When we factor in the applicable exclusion amount, you could make the argument that the many assets comprising the taxable estate each have a hand in generating a portion of the estate tax. In fact, this is how traditional tax apportionment applies. But, the 691(c) deduction is not calculated in this fashion. Instead, we can separate IRD from all non-IRD assets in the taxable estate. In this sense, IRD becomes like oil floating on water (non-IRD), so that the IRD is assumed to be last-dollar. The outcome is that all estate tax is deemed to first be generated by IRD.
As a simple example, using the current (2024) basic exclusion amount of $13,610,000, let’s assume someone has a taxable estate of $14,610,000 with IRD (in the form of a traditional IRA) of $1,000,000. In this case, the estate tax would be $400,000 (simplified to 40% of the excess over the basic exclusion amount). But, for purposes of the 691(c) deduction, it is assumed that the $1,000,000 traditional IRA generated all $400,000 of estate tax. So, the total 691(c) deduction available to the beneficiary of the IRA would be $400,000.
But, if the taxable estate was instead $15,610,000 in this case (generating an estate tax of $800,000), and the IRD (in the form of the IRA, which I know is a similar and confusing acronym) made up $1,000,000 of the taxable estate, we would have to calculate and compare the estate tax with the IRD to the estate tax without the IRD to determine what portion of the estate tax was generated by the IRD. Without the IRD, we would have a taxable estate of $14,610,000 and an estate tax of $400,000. So, our 691(c) deduction would be limited to $400,000.
Classification of Deduction
The 691(c) is classified as a miscellaneous itemized deduction not subject to the 2% floor. Below, I have illustrated where to report this deduction on Forms 1040 and 1041 from 2020 (as a slide from the video) - note that the line numbers and references may have changed:
Importantly, IRC Section 67(b)(7) clarifies that this deduction is not subject to the 2% floor for miscellaneous itemized deductions. Currently, such deductions that are subject to the 2% floor are not deductible until after the sunset of the TCJA at the end of 2025 - see IRC Section 67(g).
In other words, individuals who itemize can get the full deduction both before and after the sunset. Estates and trusts can also claim this full deduction (or their share of the deduction based on proportion of IRD received).
Other Neat Tricks
This 691(c) deduction is spread proportionately among IRD recipients. So, if the $1,000,000 IRA above had two beneficiaries each receiving one-half, they would each get a $200,000 deduction. But, there is no requirement that each share of the deduction be spread proportionately among IRD payments to a particular recipient. So, for example, if the IRA beneficiary was taking required minimum distributions from an IRA, this deduction would be used dollar-for-dollar to offset income tax until exhausted, without the need to spread it out across RMDs. This means only RMDs in later years after exhaustion of the deduction would be subject to income tax.
And, while I have a whole course and article series on the way analyzing the new inherited RMD and trust look-through rules under the proposed SECURE Act Treasury Regulations, one of the traditional “sacred cows” in IRA beneficiary planning is maximizing the IRA stretch potential to take advantage of life expectancy and 10-year distribution periods where available.
But, for clients with taxable estates and significant IRAs, planning around the 691(c) deduction is an additional tool that is rarely considered or utilized. (Keep in mind that the number of clients with taxable estates will increase if the sunset of the basic exclusion amount occurs). It could be the case that the 691(c) deduction creates a compelling method for an estate or revocable trust, as beneficiary, to use IRA or qualified plan assets to generate the liquidity needed to pay estate tax without a full income tax hit.
Conclusion
On a macro level, I believe that planning to assist beneficiaries of estates and trusts will be the new frontier of tax and estate planning. Keeping this theme, many beneficiaries will inherit IRAs (outright or in trust) in the coming years. The impact of the 691(c) deduction is often forgotten because of the seemingly-rare outcome of estates with actual estate tax liability, but post-sunset this will become increasingly important for those planners aspiring to assist wealth recipients.