Income tax consequences of an inheritance. (Estates & Trusts)by Byrne, Christopher J.
Example 1. Margaret, a widow, dies testate (with a will). Her only assets consist of 2000 shares of XYZ Corporation stock, $5,000 in a savings account and an automobile with an estate basis and current FMV of $5,000. Assume that the 2,000 shares of XYZ Corporation stock are specifically bequeathed to Margaret's sister Sally. The residuary clause in the will provides that all debts and administration expenses are to be paid from the residuary estate with the remainder passing to her sister Kathleen. The $5,000 in the savings account was used for administration expenses during 1990. In 1991, XYZ stock (still in the hands of the executor) generates $6,000 in dividend income. If no distributions are made the estate will pay income tax on the entire $6,000. However, if the automobile is distributed to Kathleen in 1991, for income tax purposes it will be deemed to carry dividend income with it to Kathleen's personal tax return calculated as follows:
In computing the taxable income of an estate there is allowed under IRC Sec. 661(a) as a deduction for distributions to beneficiaries the sum of:
1. The amount of income for the taxable year which is required to be distributed currently; and
2. Any other amounts properly paid, credited or required to be distributed for such taxable year (limited to DNI) IRC Reg. Sec. 1.66(a)-2).
This deduction is known as the income distribution deduction and is reported to the beneficiary on Form 1041 Schedule K-1. At first glance it appears that by not taking the deduction on the estate income tax return that the beneficiary could avoid picking up the tax on her personal income tax return. This is not the case. IRC Sec. 662 provides for the inclusion of amounts in gross income of beneficiaries of estates which make distributions. Thus, any distributions to Kathleen as a residuary beneficiary must be picked up on her Form 1040 to the extent that they would have been allowed as a deduction on Form 1041. The end result of this example is a gross inequity to Kathleen. Under NYS Law EPTL 11-2.1(d)(2) Sally is entitled to the dividends on the XYZ stock. However, since they have not yet been distributed to her, Kathleen is required to pay the tax on the dividends. The executor is then free to distribute them to Sally in a period with no DNI when Sally takes them in full (free of income tax).
This problem can be corrected in one of two ways:
1. Distribute assets which carry DNI at a time when the estate has little or no income; or
2. Draft the will in such a way that bequests are made that fall outside the scope of IRC Secs. 661(a) and 662(a).
Make Kathleen Wait for the
Example 2. Assume the same facts as in Example 1, except that during 1991 all of the securities along with dividends received during the administration have been transferred and paid over to Sally. Then in 1992 the automobile is distributed to Kathleen.
Given this scenario, the estate is entitled to a $6,000 income distribution deduction on the 1991 Form 1041 IRC Sec. 661(a). Sally is also required to report the dividends on her 1991 Form 1040 IRC Sec. 662(a). In 1992 when the automobile is transferred there is no deduction at the estate level nor any income to be reported by Kathleen because the estate income (DNI) is zero IRC Sec. 662(a)(2)(B). This result is more equitable than the result in Example 1 since it is Sally who ultimately receives the dividends and also pays the income tax on them. This approach, while it works in theory, may not be practical. Making Kathleen wait until a time when there is not any income before the automobile is transferred can be very frustrating.
The most practical approach to this problem would be to recognize its potential when the will is being drafted and plan accordingly. IRC Sec. 663(a) excludes from IRC Secs. 661(a) and 662(a) amounts specifically bequeathed to a beneficiary that are not paid in three or more installments. Thus, specific bequests do not qualify for the income distribution deduction under IRC Sec. 661(a), and they do not carry income to the beneficiary's Form 1040 under IRC Sec. 662(a) as long as they are not paid in three or more installments and the will does not provide for such installments IRC Reg. Sec. 1.663(a)-1(a).
In order to qualify as a specific bequest the amount of money or the identity of the property must be ascertainable under the terms of a testator's will at the date of death. in Example 1, anything in the residuary did not qualify as a specific bequest because it wasn't specifically identified and the exact amount dependent upon the amount of future administration expenses.
The problems exposed in Examples and 2 can be circumvented by taking the time when drafting the will to specifically bequeath as much of the testator's estate as possible.
Example 3. Margaret, a widow, dies testate. Her only assets consist of 2,000 shares of XYZ Corporation stock, $5,000 in a savings account and an automobile with an estate basis and current FMV of $5,000. Assume the appropriate provisions of Margaret's will are as follows:
Paragraph 1 - I bequeath my 2,000 shares of XYZ Corporation stock to sister Sally.
Paragraph 2 - I bequeath my automobile to my sister Kathleen.
Paragraph 3 - After payment of debts and administration expenses from my residuary estate, I leave the rest, residue and remainder of my estate to my sister Kathleen.
The $5,000 in savings was used for administration expenses in 1990. During 1991 the estate received stock dividend of $6,000. In December 1991, the stock and the dividends were transferred to Sally, and Kathleen took possession of the automobile. The tax consequences are as follows:
1. The receipt of the XYZ Corporation stock by Sally does not carry income to her Form 1040 because it meets the definition of a specific bequest under IRC Sec. 663(a).
2. The $6,000 in dividends pass to Sally pursuant to local law and are not considered to be a specific bequest. The dividends are an amount "properly paid" and qualify for the income distribution deduction of IRC Sec. 661(a) and must be reported on Sally's 1991 Form 1040 pursuant to IRC Sec. 662(a).
3. The receipt of the automobile by Kathleen does not carry income to her Form 1040 because it meets the definition of a specific bequest under IRC Sec. 663(a).
Be Leery of Residuary Clauses
Drafters should spend the time in the early stages of estate planning and address each asset individually or as a class. Residuary clauses that are not part of a specific estate plan should only be used to catch any unknown or immaterial assets and prevent them from passing according to the laws of intestate succession. To do otherwise could leave unsuspecting beneficiaries with a liquidity problem (plenty of tangible assets but no cash to pay their income tax).
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