When receiving a bequest, many people question whether they will be subject to income tax.[1] As a basic matter, an individual’s income “does not include the value of property acquired by gift, bequest, devise, or inheritance.”[2] However, that does not mean the individual receiving assets by bequest has no income tax consequences to consider. Those consequences include[3]:
- Whether the distribution will cause recognition of gain or loss by the estate;
- Whether there will be income tax as a result of the distribution, aside from income tax on the value of the distributed property;
- Whether the distribution is of pre-tax assets of the decedent thereby causing income tax for the beneficiary in the future, such as with pre-tax retirement plans;
- What cost basis does the beneficiary take in the asset; and
- What the holding period of the distributed assets will be for determining short-term versus long-term capital gain.
Part of understanding the answer to these questions is that bequests can be of various types. For income tax purposes, there are three types of bequests:
- Specific Bequests: These are bequests of a specific asset or dollar figure. A specific bequest may read like “I give all of my real property located in Lafayette County, Mississippi to my son, John Smith.”
- Pecuniary Bequests: These are gifts of a dollar figure, whether expressed as a fixed dollar amount or a formula. A pecuniary bequest may read like “I give $50,000 to each of my nieces and nephews.” Formula pecuniary bequests are probably most often encountered in funding shares of an estate structured to minimize estate tax on a first death such as (highly paraphrased) “I leave the smallest dollar figure to my spouse necessary to generate a marital estate tax deduction which would cause my estate to have no estate tax liability.”
- Residuary Bequests: These bequests are gifts of what is left after satisfying specific and pecuniary bequests. A typical residuary bequest may be a gift of all remaining assets (i.e. no specific asset or dollar figure) equally among the decedent’s children.
The consequences of each of these bequests can be different. As such, it is important to properly understand the different types of potential bequests in evaluating tax consequences.
Will the Distribution Cause Gain or Loss by the Estate
Distributions of assets from an estate generally do not cause gain or loss, subject to an election available to an estate.[4] This election causes gain or loss as if the asset had been sold to the beneficiary for its fair market value determined at the time of the distribution. This election, if made, applies to all distributions made by the estate during the tax year subject to certain exceptions (such as bequests of a specific sum of money or of specific property paid in three or fewer installments).[5] It is important to note that bequests which would generate a loss to the estate are subject to loss limitation rules, other than distributions in satisfaction of a pecuniary bequest, which operate to disallow a tax loss.[6]
There is, however, an important exception to the general rule above. This exception applies to distributions of gain or loss property to a beneficiary in satisfaction of a pecuniary bequest. To the extent gain or loss property is distributed in-kind to a beneficiary in satisfaction of a pecuniary bequest, the property is treated as sold to the beneficiary for an amount equal to the amount of the pecuniary bequest, thereby triggering gain or loss.[7]
Will The Beneficiary Pay Income Tax with respect to the Distributed Asset
Certain assets passing to beneficiaries may constitute pre-tax items, i.e. income earned during lifetime but not paid until after death. Those items, called income in respect of a decedent (“IRD”) are taxable to the recipient.[8] Typical IRD items include a decedent’s final paycheck, installment obligations payable to the decedent, and the decedent’s pre-tax retirement accounts. To the extent a person receives an item of IRD either directly or by right from the decedent’s estate, then that person is taxable on the income attributable to the relevant item of IRD.[9]
Beyond IRD assets, a beneficiary may recognize gain or loss upon a future sale or exchange of an asset distributed in kind. Certainly, any appreciation or decline in the value of distributed property in the beneficiary’s hands will affect tax gain or loss. However, when an asset is distributed in kind to a beneficiary, as discussed below, the beneficiary will often take the asset at a cost basis equal to that of the estate which may have “baked in” gain or loss.
To the extent of IRD assets or assets distributed in kind, beneficiaries may not all be treated equally. If, for example, two beneficiaries each receive $100,000 from a decedent, that may appear that each has received an equal share of the decedent’s assets. However, it is possible that one of the beneficiaries receives $100,000 of an IRD asset such as a pre-tax retirement plan whereas the other receives $100,000 in cash. As such, in planning or administering estates, these consequences must be considered in order to best accomplish the intent of the decedent.
Will the Beneficiary Pay Income Tax as a Result of the Distribution
Income that is accumulated by an estate, i.e. not distributed during the current year (or 65 days following the close of the current year if elected), is taxed to the estate.[10] However, income of the estate which is distributed is deductible from the estate to the extent of the estate’s distributable net income (“DNI”).[11] Generally, DNI is the taxable income of the estate subject to certain modifications, one of the most significant modifications being that capital gains and losses are typically excluded from DNI as allocable to corpus other than on a terminating distribution.[12] The effect of these rules is not to eliminate income from taxation, but to allocate the tax liability between the estate and the beneficiaries. A significant exception to distributions carrying out DNI to the beneficiary relates to specific bequests. Distributions of specific property or specific sums of money paid in not more than three installments are excluded from carrying out DNI to the specific distributee.[13] Allocation of DNI among the beneficiaries is subject to each beneficiary’s separate share of the estate as determined under a complex set of rules.
A beneficiary receiving in kind distributions from an estate is treated as having received the lesser of the assets’ basis or fair market value, adjusted for any gain or loss recognized by the estate on the distribution.[14] Other distributions from an estate, including terminating distributions (at which point capital gains will carry out in DNI without satisfying the otherwise appliable exceptions), will carry out the estate’s DNI to the beneficiaries who will be taxable to the extent of their allocable shares of DNI. When DNI is allocated to the beneficiaries, absent any requirement in the relevant instrument (Will or trust) or local law to the contrary,[15] DNI carried out to a beneficiary will constitute a pro rata share of each item of the estate’s DNI. Once again absent specific language in the governing document or local law to the contrary, the character of any DNI passing to the beneficiary will be the same character as in the hands of the estate.[16]
In allocating DNI among beneficiaries, there is a mandatory separate share rule that treats each substantially separate and independent share as a different estate.[17] This rule is intended to reduce inequities among beneficiaries by, for example, limiting DNI carrying out to one beneficiary related to assets passing to another beneficiary.
What Basis and Holding Period will the Beneficiary Take in the Distributed Asset
The basis of assets distributed from an estate is the same basis as that of the estate, adjusted for any gain or loss recognized by the estate on the distribution.[18] In this regard, it is important to understand that, other than IRD[19], assets receive a basis adjustment at death such that the cost basis in the hands of the estate equals the fair market value at the date of death of the decedent.[20] Although many people refer to this as a “step-up” in cost basis, it could result in a step-down of basis for loss assets. Assets subject to basis adjustment at death which are sold or exchanged within one year following the decedent’s death are treated as having a holding period in excess of one year.[21] As such, any assets acquired from a decedent, regardless how long held by the decedent, should be treated as long-term assets for capital gains purposes.
Conclusion
Generally, receipt of a bequest is not taxable. This is good news as many individuals fear they will owe income tax merely for receiving a bequest. However, tax consequences for beneficiaries are not nearly so simple. As indicated above, the beneficiary may receive IRD which will represent taxable income to the beneficiary when paid. The estate may recognize income that passes through to the beneficiary as DNI. The beneficiary may receive assets with imbedded, untaxed appreciation by taking such assets at the estate’s pre-appreciation cost basis (subject to holding period considerations discussed above).
As stated above, this writing is a mere glimpse into the vast set of rules related to income tax payable by a beneficiary of a bequest. There are exceptions and nuances to the items discussed. Likewise, calculation and allocation of DNI is a complex analysis that serves as its own separate topic for discussion. However, the hope is that this provides at least a summary of the consequences of receiving a bequest.
[1] I note that the discussion herein is a general discussion only. There are a number of complex rules, and exceptions, which may alter the consequences of the items discussed in this writing. Furthermore, there are a number of other tax issues involved in managing estates including estate tax liabilities, the decedent’s income tax filings, and additional items. This discussion is limited to the beneficiaries’ income tax considerations.
[2] IRC § 102.
[3] Specifically not included here are the income tax consequences of charitable bequests. This writing is limited to a discussion of bequests to individuals.
[4] IRC §§ 643(e)(3)(A)(ii) and (e)(4).
[5] IRC §§ 643(e)(4) and (e)(3)(B).
[6] IRC §§ 267(a)(1) and (b)(13). I note also that other gain or loss limitation rules may apply such as the treatment of a sale of property depreciable in the hands of the beneficiary by the estate being characterized as ordinary income under IRC § 1239.
[7] Treas. Reg. § 1.661(a)-2(f)(1). See also Kenan v. Commissioner, 114 F.2d 217 (2d Cir. 1940).
[8] IRC § 691.
[9] IRC § 691(a)(1).
[10] IRC § 663(b).
[11] IRC §§ 661 and 662. The calculation of DNI, while critically important, is beyond the scope of this writing. As such, while the concept is discussed herein, the details of what is included in DNI (which serves as a cap on both the estate’s DNI deduction and the beneficiary’s income tax on the distribution) is not covered.
[12] IRC § 643(a). Capital gains may be included in DNI pursuant to rules described in Treas. Reg. § 1.643(a)-3.
[13] IRC § 663(a)(1). To qualify for this exclusion, the specific bequest must be identifiable under Treas. Reg. § 1.663(a)-1(b). As such, certain formula bequests will not qualify since the specific property is not ascertainable until determination of certain items such as administration expenses and elections made by the executor.
[14] IRC § 643(e)(2). If an IRC § 643(e)(3) election is made, however, the amount distributed for DNI purposes is the property’s fair market value.
[15] IRC § 662(a) and Treas. Reg. § 1.652(b)-2(b).
[16] IRC § 662(b).
[17] IRC § 663(c).
[18] IRC § 643(e)(1).
[19] IRC § 1014(c).
[20] IRC § 1014. In this regard, IRC § 1014(f) requires property acquired from a decedent to have a basis equal to the fair market value as reported for estate tax purposes assuming estate tax reporting was required. Treasury recently issued final regulations related to application of this requirement.
[21] IRC § 1223(9).
