Magazine article The CPA Journal

Income Tax Consequences of an Inheritance

Magazine article The CPA Journal

Income Tax Consequences of an Inheritance

Article excerpt

Most individuals are more than happy to take possession of property left to them under the will of a deceased friend or relative. However, depending upon how the decedent's will was written there may be income tax consequences to the unsuspecting beneficiary.

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:

(Calculation omitted)

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).


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. …

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