Income In Respect Of A Decedent

Yolanda owned a nonqualified deferred annuity with a $120,000 basis and a $310,000 value when she died. Her son Marcus, the named beneficiary, receives the full $310,000. For federal income tax purposes, Marcus:

1. A.Receives a stepped-up basis of $310,000, so no income tax is due on the distributionStep-up is denied for income in respect of a decedent, and annuities fall squarely in that category.
2. B.Receives the entire $310,000 income-tax-free, the same as a life insurance death benefitThe income-tax exclusion applies to life insurance proceeds. Annuities carry their deferred gain through to the beneficiary.
3. C.Must report $190,000, but it is taxed at long-term capital gain rates because the contract was held for many yearsAnnuity gain is always ordinary income. Holding period does not convert it to capital gain.
4. D.Must report $190,000 of ordinary income, because annuity gain is income in respect of a decedent and receives no basis step-upCorrect. Marcus inherits Yolanda's $120,000 basis; the remaining gain is ordinary income as he receives it.

Why: An annuity's untaxed gain is income in respect of a decedent. Unlike stock or real estate, an annuity receives NO step-up in basis at death. The beneficiary inherits the owner's basis and must include the gain in income as it is received. Here $310,000 minus the $120,000 basis leaves $190,000 of ordinary income for Marcus. The clue is the pairing of a large gain with a nonqualified annuity passing at death.

Ignatius Pellworth dies holding two assets: a taxable brokerage account containing stock he bought for $200,000 now worth $900,000, and a traditional IRA worth $900,000 funded entirely with deductible contributions. Both pass to his adult daughter. How do the two assets compare in her hands for income tax purposes?

1. A.The brokerage account receives a step-up in basis to date-of-death value, while the IRA receives no step-up and every withdrawal is ordinary income to her as income in respect of a decedent.Correct. Unrealized appreciation is stepped up; tax-deferred retirement accounts are not, and they keep their ordinary income character in the beneficiary hands.
2. B.Both assets receive a step-up in basis to $900,000, so she may withdraw from either without income tax.Incorrect. There is no step-up for a traditional IRA. Applying one to a tax-deferred account is the most common error on this point.
3. C.Neither asset receives a step-up, so she takes his $200,000 basis in the stock and the IRA is taxable as withdrawn.Incorrect as to the stock. Appreciated property held in a taxable account at death does receive a basis adjustment to date-of-death value.
4. D.The IRA is received free of income tax because estate tax and income tax cannot both apply to the same asset.Incorrect. Both can apply. The relief is an itemized deduction for the estate tax attributable to the IRD, not an exemption from income tax.

Why: The two assets are treated in opposite ways. The taxable brokerage account receives a step-up in basis to its fair market value at death, so the $700,000 of appreciation that accrued during his lifetime escapes income tax entirely and she could sell immediately with essentially no gain. The traditional IRA receives NO step-up. It is income in respect of a decedent, meaning income the decedent had earned or accrued a right to but had not yet recognised, and it retains its ordinary income character in the beneficiary hands. Every dollar she withdraws from the inherited IRA is taxable to her as ordinary income at her own marginal rate, and the account must be drawn down under the applicable inherited-account distribution rules. Where the estate actually paid federal estate tax, the beneficiary may claim an itemized deduction for the portion of that estate tax attributable to the IRD, which prevents the same value from being fully taxed twice.

Clemence inherited a nonqualified deferred annuity that her father funded entirely with contributions made in 1979, and she separately owns a nonqualified deferred annuity she funded herself in 2016. Each contract now holds substantial gain, and she takes a partial withdrawal from each. How does the ordering of taxable income differ between the two contracts?

1. A.Both contracts distribute gain first, because all nonqualified annuities use LIFO orderingIncorrect. LIFO applies to investment made after August 13, 1982. Older contributions retain FIFO treatment.
2. B.Both contracts recover basis first, because nonqualified annuities are funded with after-tax dollarsIncorrect. After-tax funding creates basis, but it does not determine ordering. Modern contracts distribute gain first.
3. C.The inherited contract distributes gain first because it was inherited; her own contract recovers basis firstIncorrect. Inheriting a contract does not change its ordering rule, and the direction stated here is backward.
4. D.The 1979-funded contract recovers basis first under FIFO; the 2016 contract distributes gain first under LIFOCorrect. Pre-August 14, 1982 investment is grandfathered into FIFO treatment; later investment is subject to income-first LIFO ordering.

Why: Amounts attributable to investment made AFTER August 13, 1982 come out on a last-in first-out basis: gain is distributed first and is fully taxable ordinary income, with basis recovered only after all gain is exhausted. Contributions made BEFORE August 14, 1982 are grandfathered and come out first-in first-out, so basis is recovered before any gain is taxed. Her father's 1979 contract therefore uses FIFO, while her own 2016 contract uses LIFO.

Casimir Aalto dies owning two contracts. CONTRACT ONE is a nonqualified deferred annuity with a 180,000-dollar cost basis and a 520,000-dollar value, payable to his son. CONTRACT TWO is a life insurance policy on his own life with a 900,000-dollar death benefit, also payable to his son. Both were included in Casimir taxable estate and federal estate tax was paid. How is each treated in the sons hands?

1. A.Both contracts receive a step-up in basis at death, so the son recognizes no income on either.Wrong as to the annuity. Income in respect of a decedent is expressly denied a basis step-up, which is why the deferred gain remains taxable.
2. B.Both are income in respect of a decedent, so the son reports the annuity gain and the entire life insurance benefit as ordinary income, with an estate tax deduction against each.Wrong. Life insurance death proceeds are excluded from gross income and are not income in respect of a decedent.
3. C.The annuity gain is income in respect of a decedent, taxable to the son as ordinary income with no basis step-up but with a deduction for the federal estate tax attributable to it; the life insurance benefit is received income-tax-free.Correct. Only the annuity carries deferred income to the beneficiary, and the estate tax deduction exists precisely because that item bore both taxes.
4. D.The annuity is received income-tax-free because estate tax was already paid on it, and only the life insurance benefit is taxable.Wrong and reversed. Paying estate tax does not eliminate income tax on income in respect of a decedent, and life insurance proceeds are the item that escapes income tax.

Why: The two contracts are treated in fundamentally different ways. The annuity gain of 340,000 dollars is INCOME IN RESPECT OF A DECEDENT: it is income Casimir had earned but never recognized, and death does not erase it. There is no step-up in basis for that gain, and the son reports it as ORDINARY income as he receives it. Because the same 340,000 dollars was also subjected to federal estate tax, the son is entitled to an income tax deduction for the portion of the federal estate tax attributable to that item, which mitigates the double taxation. The life insurance death benefit is not income in respect of a decedent at all: it is excluded from gross income under the death benefit exclusion, so the son receives all 900,000 dollars income-tax-free even though it too was included in the taxable estate and bore estate tax. No deduction is available or needed for it because no income tax is imposed.