By Andy Ives, CFP®, AIF®
IRA Analyst

My son does not much care for broccoli. However, he knows it is for the greater good, and I insist he grow strong and healthy. As long as he lives under my roof, I could feed him broccoli for both lunch and dinner. Double broccoli is legal. But we both agree that would be excessively penal. The boy knows that if he eats broccoli for lunch, it will not be on the table for dinner. If he does not eat broccoli for lunch, then he must eat broccoli at dinner to stay in compliance with house rules.

A recent court case (Schermer vs. Commissioner of Internal Revenue) had nothing to do with vegetables. Nevertheless, as repulsive as double broccoli is to my son, the Schermer case dealt with an equally unappetizing topic – legal double taxation.

Jill Schermer inherited IRA accounts from her husband and took distributions. She reported these distributed amounts on her Form 1040. She also claimed the income in respect of a decedent (“IRD”) deduction on her income tax return. Ms. Schermer contended she was entitled to the deduction in order to help offset estate taxes paid.

The problem was that estate taxes were never paid. There was no broccoli eaten by the estate of her late husband. The fact that no estate taxes were paid comes as little surprise. With the estate tax exemption amount for 2019 set at $11,400,000 ($22,800,000 per couple), the Tax Cuts and Jobs Act essentially made the IRD deduction nearly extinct for all but the very largest estates.

How does the IRD deduction work? IRD is income that was earned by the decedent but collected by the beneficiary. The beneficiary pays the income tax when the income is ultimately received. (For example, distributed from an inherited IRA.) IRD items are included in the decedent’s estate and are subject to estate tax, and then are also taxable to the beneficiary as income when paid out. Double broccoli – lunch and dinner – estate and income tax.

The IRS agrees that double broccoli is too harsh. Eat it for lunch or dinner, but not both.

Know that IRD has not yet been reported on any income tax return. The one who receives the IRD (from an inherited IRA in our example above) is the one responsible for paying the income tax on it. The IRD deduction partially offsets potential double taxation by allowing the beneficiary an income tax deduction for the amount of federal estate tax paid on the IRD item. However, if there was no federal estate tax paid, (which was the case with Jill Schermer and will be the case with many others), then there is no IRD deduction. With nothing to offset, income taxes are due.

Eat broccoli for lunch (pay estate taxes), and you may be able to take the IRD deduction for your income tax dinner. If there is no broccoli for lunch, then income tax on IRD will be on the table at suppertime. No deduction. House rules.

Please pass the butter.

(Note: There is no IRD deduction for state estate taxes. This results in double taxation on the state level without the benefit of at least a partial offset from the IRD deduction. This affects more estates since some states are “decoupling” – choosing to apply their own state estate tax regardless of whether a Federal estate tax credit is available.)