Income in Respect of a Decedent: Tax Rules for IRAs, Installment Sales, Wages, and Other Income After Death
Income inherited after someone's death is not always tax free.
One of the most important exceptions is income in respect of a decedent, commonly called IRD.
Internal Revenue Code Section 691 generally applies when a decedent had a right to income that was not properly included on the decedent's final income tax return. When that income is later received, it generally remains taxable to the estate, beneficiary, or other person who receives the right to the income.
Common IRD items can include:
- Traditional IRA and retirement plan distributions
- Unpaid wages and bonuses
- Cash basis business accounts receivable
- Certain accrued interest
- Deferred compensation
- Installment sale obligations
- Certain partnership payments
What Is Income in Respect of a Decedent?
Section 691 generally applies to items of gross income that the decedent had a right to receive but that were not properly included in the decedent's taxable income for the year of death or an earlier year.
The decedent's accounting method can be important.
Example
Assume a cash method consultant completed work before death and earned a $25,000 fee, but the client had not yet paid it.
The receivable can be income in respect of a decedent.
If the estate collects the receivable, the estate generally reports the income. If the right passes directly to a beneficiary, the beneficiary generally reports it when received.
IRD Is Different From Ordinary Inherited Property
An appreciated capital asset and an IRD item can produce very different tax results at death.
Appreciated Property
Assume a parent owns stock with an adjusted basis of $100,000 and a fair market value of $500,000 at death.
If Section 1014 applies, the inherited basis generally becomes $500,000.
Income in Respect of a Decedent
Now assume the parent instead has a right to receive $500,000 of taxable deferred compensation that has not been included in income.
The right can have estate tax value, but Section 1014(c) generally prevents the normal fair market value basis adjustment from eliminating the income tax.
For a broader discussion, see inherited property basis after death.
Who Pays Tax on IRD?
The Estate
If the estate acquires the right from the decedent and receives the income, the estate generally reports the IRD on Form 1041.
A Beneficiary Who Receives the Right Directly
If a beneficiary acquires the right because of the decedent's death and the estate never owns the right, the beneficiary generally reports the IRD when received.
A Beneficiary Who Receives the Right From the Estate
An estate can distribute a right to IRD to a beneficiary. When the beneficiary succeeds to that right through the applicable estate distribution rules, the estate generally does not recognize the IRD merely because the right is distributed. The beneficiary generally reports the income when later received.
IRD Keeps Its Tax Character
Section 691 generally preserves the character the income would have had if the decedent had lived and received it.
- Compensation generally remains compensation income
- Interest remains interest
- Installment gain generally retains the character of the original gain
- An item that would have been capital gain generally retains capital gain character
IRD Versus Income Earned After Death
| Situation | General Tax Treatment |
|---|---|
| Compensation earned before death but unpaid | Potential IRD |
| Interest accrued before death but not reported | Potential IRD |
| Interest earned by an estate account after death | Post death estate income |
| Cash basis receivable for work completed before death | Potential IRD |
| Rent earned by estate property after death | Post death estate income |
| Appreciation in inherited stock before death | Generally reflected in Section 1014 basis |
| Taxable traditional IRA distribution | IRD to the extent attributable to the decedent's taxable balance |
Traditional IRAs Are a Major Source of IRD
An inherited traditional IRA generally does not receive a Section 1014 basis adjustment that makes its taxable balance tax free.
If the decedent had deducted contributions and the account contains earnings that had never been taxed, distributions generally remain taxable to the beneficiary under the applicable retirement account rules.
Inherited IRA Example
Assume a decedent has a traditional IRA worth $800,000 and no nondeductible IRA basis.
The beneficiary does not generally receive an $800,000 income tax basis that eliminates future tax.
Taxable distributions from the inherited IRA remain subject to income tax.
What If the Decedent Made Nondeductible IRA Contributions?
The beneficiary does not pay income tax again on properly established after tax IRA basis.
The taxable and nontaxable portions must be determined under the applicable IRA rules, which makes historical Form 8606 records important.
Roth IRAs Can Also Have an IRD Component
A qualified Roth IRA distribution generally can be tax free.
However, if an inherited Roth IRA distribution is not otherwise qualified, earnings attributable to the period ending with the decedent's death can constitute IRD. Earnings arising after death generally are income of the beneficiary.
Unpaid Wages and Bonuses Can Be IRD
Wages and other employee compensation earned before death but unpaid at death generally are IRD.
Payment During the Calendar Year of Death
Current IRS guidance generally provides that compensation paid after death during the same calendar year is not reported as federal income taxable wages in Form W-2 box 1, but generally remains subject to Social Security and Medicare taxes.
The taxable payment to the recipient generally is also subject to the applicable Form 1099-MISC reporting rules.
Payment After the Calendar Year of Death
Compensation paid after the calendar year of death generally is not subject to federal income tax withholding or Social Security and Medicare withholding under the IRS rules for post death wage payments.
The recipient still generally reports the taxable IRD.
Cash Basis Business Receivables Can Be IRD
IRD frequently arises when a cash basis business owner dies with unpaid receivables.
Examples can include professional fees, commissions, consulting fees, contractor receivables, and other amounts for services completed before death.
Business Receivable Example
A cash basis attorney completes work before death and has a $75,000 account receivable.
If the estate later collects the receivable, the amount generally is IRD to the estate rather than a tax free collection of an asset with a stepped basis.
Accounting Method Can Change the Answer
If a cash method decedent had not received income before death, the item can become IRD.
If an accrual method decedent already properly accrued the income on the final return, later collection generally does not create IRD again.
Accrued Interest Can Be IRD
Interest attributable to the period before death that was not previously included in income can be IRD.
Interest attributable to the period after death generally is income of the estate or beneficiary holding the underlying investment.
Installment Sales Require Special IRD Rules
If a taxpayer dies while holding an installment obligation, the remaining unreported installment gain generally does not disappear.
Section 691 treats the unreported profit embedded in the installment obligation as income in respect of the decedent.
Death Does Not Normally Accelerate All Installment Gain
The transmission of an installment obligation at death generally is not itself a taxable disposition that accelerates all remaining gain.
If the estate or beneficiary continues collecting the note, the successor generally uses the same gross profit percentage the decedent would have used.
Installment Sale Example
Assume an inherited installment note has a 60 percent gross profit percentage.
If the successor receives a $50,000 principal payment, approximately $30,000 generally represents installment gain, assuming no other adjustment.
Special Rules Apply if the Installment Note Is Disposed Of
Different rules can apply if the estate or beneficiary sells, exchanges, cancels, compromises, transfers, or otherwise disposes of an installment obligation.
Special rules also apply to transfers to the obligor and certain transactions involving related persons.
What Happens if an IRD Right Is Distributed to a Beneficiary?
When an estate properly distributes an IRD right to a specific or residuary beneficiary who succeeds to that right, the estate generally does not recognize the IRD merely because the right was distributed.
The beneficiary generally includes the income when the beneficiary later receives it.
Selling or Gifting an IRD Right Can Accelerate Tax
A different rule generally applies when the holder sells, exchanges, gives away, or otherwise transfers an IRD right outside the applicable succession rules.
Section 691 can require the transferor to recognize income based on the fair market value of the right or consideration received.
A gift of an IRD right can therefore create taxable income to the donor even though the donor receives no cash.
Does IRD Go on Form 1041?
If the estate receives the IRD, it generally reports the income on Form 1041 according to the character of the item.
For the broader post death filing rules, see What Tax Returns Are Required After Someone Dies?
Does IRD Appear on a Beneficiary Schedule K-1?
It can.
If the estate receives IRD and the fiduciary income tax rules carry that income to a beneficiary, the amount can enter the estate's DNI computation and be reported on Schedule K-1.
If a beneficiary receives an IRD right directly, the income generally is reported directly by the beneficiary rather than first passing through Form 1041.
For a broader discussion, see trust distributions and beneficiary taxation.
The Section 691(c) Estate Tax Deduction Can Be Valuable
An IRD right can be included in the decedent's gross estate for federal estate tax purposes and also produce taxable income when the recipient later receives it.
Section 691(c) can allow the recipient an income tax deduction for the federal estate tax attributable to the IRD.
How Does an Individual Claim the Section 691(c) Deduction?
Current IRS guidance provides that an individual generally claims the Section 691(c) estate tax deduction as an itemized deduction on Schedule A, line 16, for the same year the related IRD is included in income.
An estate entitled to the deduction generally reports it on Form 1041.
When an estate distributes IRD, the associated deduction can also be allocated to beneficiaries under the applicable fiduciary reporting rules.
IRD Can Have Related Deductions
Section 691(b) also addresses certain deductions and credits relating to obligations of the decedent that were not properly allowable on the decedent's final return.
Potential items can include qualifying business expenses, interest, taxes, income producing expenses, depletion, and foreign tax credits.
Being Included in the Estate Does Not Make IRD Tax Free
Federal estate tax and federal income tax are separate systems.
An IRD asset can have value included in the gross estate and still produce taxable income when later received.
Section 691(c) can mitigate part of this overlap when federal estate tax was attributable to the IRD, but it does not transform IRD into ordinary Section 1014 property.
Community Property Does Not Automatically Eliminate IRD
Qualifying community property can receive favorable basis treatment under Section 1014(b)(6), but that rule does not convert a right to IRD into an ordinary stepped basis asset.
The ownership of the income right, community property rules, beneficiary designation, and federal IRD rules must be coordinated.
California Can Also Tax IRD
Current California Form 541 guidance specifically identifies unpaid compensation received by a decedent's estate as an example of income in respect of a decedent.
For a decedent who was a California resident at death, California generally requires the estate to report its entire income. For a nonresident decedent, California generally focuses on California source estate income.
Records That Should Be Preserved for IRD
- Final Form 1040
- Prior income tax returns
- Prior Forms 8606
- IRA and retirement plan statements
- Beneficiary designations
- Employer compensation records
- Accounts receivable records
- Cash versus accrual accounting records
- Installment sale agreements
- Form 6252 calculations
- Promissory notes
- Installment sale gross profit percentage
- Accrued interest records
- Form 706 and estate tax computations
- Schedule K-1 from Form 1041
- Records identifying who acquired each income right
Frequently Asked Questions
Is income in respect of a decedent taxable?
Generally, yes. IRD generally is included in income when later received by the estate or other recipient.
Does IRD receive a step up in basis?
Generally, no. Section 1014(c) excludes rights to IRD from the normal Section 1014 basis adjustment.
Is an inherited traditional IRA IRD?
The taxable balance attributable to the decedent generally represents IRD. Properly established nondeductible IRA basis can reduce the taxable portion.
Who pays tax on IRD?
The estate, beneficiary, or other successor generally reports the income depending on who acquires and receives the right.
Does IRD go on Form 1041?
If the estate receives the IRD, generally yes. If the beneficiary receives the right directly, the beneficiary may report the income directly.
Is unpaid salary after death taxable?
Compensation earned before death but unpaid at death generally is IRD. Special payroll and information reporting rules apply to payments after death.
What happens to a seller financed installment sale when the seller dies?
Death generally does not accelerate all remaining installment gain solely because the note passes to an estate or beneficiary. The successor generally continues the decedent's gross profit percentage as payments are collected.
Can an estate distribute an IRD receivable to a beneficiary?
Yes. A beneficiary who succeeds to the right through the applicable estate distribution rules generally reports the income when later received.
Can IRD be reported on Schedule K-1?
Yes, when IRD received by the estate is carried out to a beneficiary under the fiduciary income tax rules.
Is there a deduction for estate tax paid on IRD?
Potentially. Section 691(c) provides a deduction for federal estate tax attributable to IRD when the statutory requirements are satisfied.
Identify IRD Before Estate Assets Are Distributed
An IRA, installment note, receivable, accrued interest item, or compensation claim can look like ordinary inherited property while retaining a substantial income tax liability.
Identifying IRD early helps determine the correct taxpayer, Form 1041 and Schedule K-1 reporting, installment sale treatment, and potential Section 691(c) deduction.
Estate, Trust and Inheritance Tax ServicesFinal Takeaway
Income in respect of a decedent is a major exception to the idea that inherited property receives a new fair market value basis and can then be received tax free.
Section 691 preserves income that had not yet been taxed when the taxpayer died.
The estate, beneficiary, or other recipient generally reports that income when received, and the income generally retains the character it would have had in the decedent's hands.
Traditional IRAs, unpaid compensation, cash basis receivables, accrued interest, and installment obligations are common examples.
