Income in Respect of a Decedent

Income in respect of a decedent is income a person had a right to receive at death but which was not properly includible on their final income tax return under their method of accounting. IRS Publication 559 puts it in one sentence: "All income the decedent would have received had death not occurred that wasn't properly includible on the final return ... is income in respect of a decedent." Internal Revenue Code section 691, headed "Recipients of income in respect of decedents," is the governing provision, and the Instructions for Form 1041 abbreviate the phrase to IRD.

The everyday examples are unremarkable: a final paycheck or commission unpaid at death, interest accrued on a bond but not yet credited, a consulting invoice outstanding. The consequential example is a traditional IRA or 401(k) balance, which is the largest asset in many estates and which is IRD in its entirety to the extent it was never taxed.

Why the concept exists at all is the part worth understanding. Property inherited from a decedent normally takes a new basis equal to its date-of-death value, so a lifetime of unrealized appreciation escapes income tax. Section 1014(c) carves a hole in that rule: "This section shall not apply to property which constitutes a right to receive an item of income in respect of a decedent under section 691." Without that sentence, a decedent's unpaid salary would arrive at the heirs with a basis equal to its face value and would never be taxed to anyone. With it, income that was earned but untaxed during life stays taxable, and the person who collects it pays.

Three people can be the taxpayer, and section 691(a)(1) names them in order. The decedent's estate, if the estate acquires the right; the person who acquires the right by reason of the death, if the estate never holds it, which covers a beneficiary named on an account; or the person to whom the estate distributes the right, if the estate passes it along before collecting. Whichever of the three actually receives the money reports it in the year received.

Character survives the death. Section 691(a)(3) treats the right to the income as though the recipient had acquired it "in the transaction in which the right to receive the income was originally derived," so the money keeps the character it would have had in the decedent's hands. Unpaid wages are ordinary income to the heir; an installment obligation on a capital asset keeps its capital gain character and its gross profit percentage. This is the same mechanism that denies a basis reset to the appreciation embedded in employer stock distributed under a net unrealized appreciation election.

Trying to sell or give away the right accelerates the tax rather than avoiding it. Section 691(a)(2) provides that where the estate or the person who received the right transfers it, the fair market value of the right at the time of the transfer, plus any excess consideration, goes into gross income immediately. Transmission at death to the estate, and transfer to the person entitled to receive it by reason of the death, are expressly not transfers for this purpose. Canceling an installment obligation counts as a transfer, and where the decedent and the obligor were related persons, the obligation's fair market value is treated as not less than its face amount.

The section 691(c) deduction is the most missed item in the whole area. The same dollar can be taxed twice: once in the decedent's gross estate for estate tax, and again as income to whoever receives it. Section 691(c) answers that by allowing the recipient an income tax deduction for the estate tax attributable to the income. Three points decide whether anyone actually gets it. It exists only where federal estate tax was in fact paid, so an estate below the filing threshold generates none. It must be claimed in the same tax year the income is reported, so a beneficiary spreading withdrawals over several years has to claim it in each of them. And it is an itemized deduction, taken by individuals on Schedule A and by an estate or trust on Form 1041, but section 67(b)(7) expressly removes it from the category of miscellaneous itemized deductions, so the suspension of that category does not reach it. Where the income is capital gain, the gain itself is reduced by the deduction rather than the deduction being taken separately.

Deductions travel the same way, under section 691(b). Business expenses, interest, taxes and income-producing expenses that the decedent owed but which are not allowable on the final return become deductible when paid, by the estate, or by the person who took the property subject to the obligation where the estate was not liable for it. Depletion is on the same list but follows the income rather than the payment: it goes to whoever receives the income the deduction relates to, in the year they receive it.

1. Identify what the decedent had a right to receive at death but had not received, and confirm it was not properly includible on the final return under the decedent's accounting method. A cash-basis taxpayer generates far more of these items than an accrual-basis one.

2. Determine who collects it: the estate, a named beneficiary, or someone the estate distributes the right to.

3. That person reports it in the year received, with the character it would have had to the decedent.

4. If federal estate tax was paid on the estate, compute the section 691(c) deduction and claim it in the same year the income is reported.

A hypothetical showing the section 691(c) computation. Marcus dies with a gross estate of $20,000,000, taxed at the top rate at the margin. Two of its items are income in respect of a decedent: a traditional IRA worth $3,000,000 and $250,000 of unpaid consulting fees, so the items total $3,250,000. The estate owes no deductible expenses relating to them.

The estate's federal estate tax comes to $2,000,000. Recomputed without the $3,250,000 of IRD, at a 40% marginal rate, the tax would have been $2,000,000 − ($3,250,000 × 40%) = $2,000,000 − $1,300,000 = $700,000. The difference, $1,300,000, is the estate tax attributable to the IRD.

Marcus's daughter inherits the IRA and empties it in a single year. She reports $3,000,000 of ordinary income. Her share of the deduction is the attributable estate tax multiplied by her share of the IRD items: $1,300,000 × ($3,000,000 ÷ $3,250,000) = $1,200,000. Claiming it in that same year reduces the income she is taxed on to $1,800,000. Failing to claim it, which is common, costs her the full benefit permanently, because the deduction cannot be moved to another year.

Pros

• The rule is coherent rather than punitive: it taxes income once, to somebody, rather than letting the timing of a death erase it.

• Character carry-over can work in the recipient's favor, since capital gain to the decedent stays capital gain to the heir.

• The section 691(c) deduction genuinely offsets the double tax where estate tax was paid, and it is not caught by the suspension of miscellaneous itemized deductions.

• Deductions in respect of a decedent follow the income, so the expenses that generated it are not stranded.

Cons

• It is the reason an inherited retirement account is fully taxable while an inherited taxable account is not, which surprises nearly every heir.

• The tax lands on the recipient, who may be in a higher bracket than the decedent ever was, and the timing is largely outside their control.

• The section 691(c) deduction must be claimed in the same year as the income, so a missed year is lost rather than carried.

• No estate tax means no deduction, so most heirs get the income tax without any offset at all.

• Attempting to assign or sell the right accelerates the tax instead of shifting it.