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TAX COURT SAYS NO ESTATE TAX DISCOUNT FOR IRA INCOME TAXES

November 17, 2005

Retirement accounts present one of the thornier problems in estate planning. Not only are they subject to estate tax (top rate 47%), but the beneficiaries have to pay income tax when the IRA amounts are distributed at rates up to 35%.

This double tax hit explains why some folks have charities as their Individual Retiremennt Account Beneficiaries. It also illustrates why the 2005-only waiver of the 50%-of-AGI limit on cash donations is useful to some taxpayers - they can withdraw their IRAs, donate the entire amount to a charity, and get full income and gift tax deductions while solving a potential estate tax problem.

DOES THE DOUBLE-HIT MAKE IRAs LESS VALUABLE?

Doris Kahn died in Glencoe, Illinois in 2000. She left behind two IRAs with assets totaling $2,620,410. Ms. Kahn's estate tax form, Form 706, reported the IRAs at a reduced value of only $2,103,416 to reflect the income tax that would be payable when the IRA assets are paid to beneficiaries.

In a way, such a discount makes sense. Courts have allowed discounts in the value of corporation stock to reflect taxes that the corporations would incur if they sold their assets, for example. Why not apply that logic to IRAs?

IT'S THE IRA ASSETS, NOT THE IRA ITSELF

The Tax Court said that the argument fails because an IRA cannot be sold. Only its assets can be sold, so only its assets can be valued.

The tax law standard for determining value is what a hypothetical willing buyer would pay a willing seller for assets, with both parties informed of the facts involved. A hypothetical buyer of a corporation with tax liabilities would pay less for the stock of a corporation with deferred tax liabilites because the buyer would eventually have to pay them. In contrast, a buyer of IRA assets would not assume any liability for IRA taxes, so there's no reason to discount his purchase price. Certainly the seller isn't going to discount the price, regardless of the taxes.

The Kahn estate didn't lose it's case for lack of trying. In arguing for the discount it used valuation cases involving, among other things, lottery payments and contaminated land. The Tax Court was not moved:

The main problem with all of the arguments based on the above-cited cases is that the estate is trying to draw a parallel where one does not exist by comparing this situation to situations where a reduction in value is appropriate because a willing buyer would have to assume whatever burden was associated with that property--paying taxes, zoning costs, lack of control, lack of marketability, or resale restrictions. In this case, a willing buyer would be obtaining the securities free and clear of any burden. We have taken note of the fact that the IRAs themselves are not marketable. Therefore, in determining their value under the willing buyer-willing seller test, we must take into account what would actually be sold--the securities. (emphasis added)

The tax law does provide some relief for IRA beneficiaries: when they do report the IRA proceeds as income, the taxable distribution is considered "income in respect of a decedent," or IRD. Taxpayers receiving IRD are allowed an income tax deduction for the estate tax paid on account of the IRD. Think of a mugger leaving you cab fare to get home.

The Moral: When you file an estate tax return, your full IRA value is going to be subject to tax. If you are fortunate enough in life to have an estate tax problem, the IRA problem isn't going away on its own. If you are charitably inclined, the IRA makes a great gift. It's an especially nice gift in 2005 because the 50% of AGI charitable deduction cap is raised to 100%. But act now - the cap reverts to 50% January 1!

Cite: Estate of Doris F. Kahn v. Commisioner, 125 T.C. No. 11.

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