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Sunday, May 5, 2024
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Case Studies |
IRD Assets Make Better Bequests
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Case:
James Johnson passed away two years ago and in his will he made various pre-residuary property bequests. He then left the estate's residue in various percentages to a number of tax-exempt charities. In total, the percentage of the residual to be transferred to the charities was 25%, representing approximately $500,000 of value. The will gave the executor, Jeffrey Nelson, the power to sell any assets or to distribute assets in-kind. Among the assets in the decedent's residuary estate were Series E bonds and Series HH bonds that had accrued reportable income. James had not elected under Code Sec. 454(a) to report the bond interest annually and, therefore, the accrued interest on the bonds is income in respect of a decedent (IRD). Generally, the interest is treated as includable in the decedent's estate and is taxable either to the decedent, the estate or estate beneficiaries. However, since neither James nor his estate elected to report the increase in the bonds' redemption price each year as it accrued (nor did the estate intend to do so), the beneficiaries of the estate would be required to report the accrued interest when the bonds are redeemed.
Question:
Mr. Nelson would like to use the most tax-effective method in making the $500,000 gifts to the named charities under the will. Instead of distributing other estate assets such as publicly traded securities in fulfillment of the charitable bequests, can the Series E and Series HH bonds to fulfill those bequests to charity? If so, will the estate and/or the charities be required to recognize income from the bonds that had accrued at the time of James' death resulting in taxation on the bonds' interest accruals?
Solution:
Mr. Nelson decided that the best course of action was to pose these questions to his attorney, Rhonda Young. In researching these questions, she came across PLR 9845026. This Ruling involved a residuary bequest that was satisfied, in part, by distributions of U.S. Savings bonds at the executor's discretion. Based upon the Ruling's facts and relevant law, the IRS ruled that the estate's distributions of the bonds to the charities will not result in income recognition to the estate. Rather, the accrued interest attributable to the bonds, as of the distribution date to the charities, will be included in the charities' gross income when the bonds are redeemed or mature. Therefore, the income will be exempt from tax since the organizations are Sec. 501(c)(3) charities.
The Ruling went on to say that under Reg. 1.661(a)-2(f) an estate realizes no gain or loss on property paid or distributed in-kind unless the distribution is in satisfaction of a specific dollar amount or specific property other than that distributed. It also cited Reg. 1.691(a)-4(b)(2), which states that if an estate transfers a right to IRD to a residuary legatee, only the residuary legatee must include the IRD in gross income when received.
As a result of her research, Ms. Young counsels the executor, Mr. Nelson, to satisfy the charitable bequests as much as possible with the Series E and Series HH bonds. The bonds will be distributed to the various named charities in-kind. As a result of distributing the bonds, the accrued income will not be attributable to the estate, but will be reportable by charities. Since the charities are tax-exempt, no income tax will be owed on the bonds' accrued interest. This is good news for the estate, its noncharitable beneficiaries and, of course, the charities.
Recommendation: A person who is making noncharitable as well as charitable bequests should attempt to arrange for the charitable bequests to be satisfied with items of IRD. Wills should be drafted specifically directing charitable bequests to be paid with IRD, to the extent of IRD, and out of other assets of the estate only to the extent that there is insufficient IRD to satisfy the charitable bequests. IRD charitable bequests both reduce the taxable estate by their full value and allow the estate or noncharitable beneficiaries to avoid income taxation on IRD, resulting in less tax erosion for noncharitable beneficiaries.
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