IRAs in the Gross Estate Not Reduced for Income Taxes

By Peter C. Barton

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Background

IRC section 408(e)(1) exempts IRAs from income tax. IRC section 408(d)(1), however, includes IRA distributions in the gross income of the distributee. This section, combined with IRC section 691(a)(1)(B), includes IRA distributions in the gross income of beneficiaries when IRAs are inherited. IRAs are “income in respect of a decedent” under IRC section 691, and therefore do not receive an income tax basis equal to fair market value (FMV) on the date of the decedent’s death under IRC section 1014(a).

Under IRC section 2039(a), IRAs are includable in the gross estate and, therefore, are subject to estate and income tax. IRC section 691(c) eases this double taxation by providing a deduction for the estate tax paid on the IRAs. This deduction is allowed on the income tax returns of the beneficiaries as they report the IRA distributions in their income.

Case law has established that the FMV of property is the price a willing buyer and a willing seller agree on, neither being forced to sell and both having reasonable knowledge of the relevant facts. Both the willing buyer and the willing seller are attempting to maximize their advantage. This definition of FMV is objective, and the buyer and seller are hypothetical persons; their characteristics may differ from an actual buyer or seller in a given case.

The Facts and Arguments

When Doris Kahn died, she owned two IRAs with a combined value exceeding $2,600,000. The IRA trust agreements provided that the IRAs could not be sold; however, the assets in the IRAs (publicly traded securities) could be sold. The estate reduced the value of the IRAs by about 22% due to the income taxes to be paid by the beneficiaries when the assets in the IRAs were distributed to them. The IRS disallowed the reductions.

The estate argued that because the IRAs could not be sold, the only way to create an asset that a willing seller could sell was to distribute the assets in the IRAs to the beneficiaries, who could then sell these assets. The cost of this distribution would be is the income tax the beneficiaries must pay as a result. The estate concluded that this cost should reduce the value of the IRAs in the gross estate. To support its position, the estate cited the following situations where courts have allowed reductions in the value of assets in the gross estate: cases allowing future tax detriments or benefits; cases allowing lack of marketability discounts; and cases allowing reductions in value for zoning or decontamination of real property.

The estate cited Estate of Davis [110 TC 530 (1998)], where the donor gifted stock in a closely held corporation that owned appreciated assets. The Tax Court allowed a discount on the value of the stock for gift tax purposes due to the income tax that would be paid if the corporation sold the appreciated assets. No liquidation of the corporation was planned. The court concluded that the hypothetical buyer would expect such a discount. The same reasoning would apply for estate tax valuation.

The estate then cited Estate of Algerine Smith [198 F3d 515 (5th Cir. 1999), rev’g 108 TC 412 (1997)], where the Court of Appeals ruled that an IRC section 1341 income tax benefit reduced the value of a deductible claim against the estate. The amount of the claim was uncertain at her death. The estate then cited Estate of Davis again, with regard to a lack of marketability discount, which the Tax Court allowed in valuing the stock. In addition, the estate cited Shackleford v. U.S. [262 F3d 1028 (9th Cir. 2001)], where the court allowed a discount for unassignable lottery payments in the taxpayer’s gross estate. Finally, the estate cited cases where the courts have allowed discounts either to clean contaminated land or to pay legal fees to obtain favorable zoning.

The Ruling

In Estate of Kahn, the Tax Court ruled that the value of the IRAs in the gross estate cannot be reduced for the anticipated income tax, because the seller of the IRA assets would pay the income tax. A willing buyer would pay the full amount for the IRA assets because the buyer obtains the IRA assets free and clear of the income tax liability. The Tax Court used this point to distinguish the case at hand from all of the cases cited by the estate. In those cases, the income tax liability or marketability restrictions would be assumed by the hypothetical buyer, who would therefore insist on a lower price for the assets in question.

On the marketability restrictions, the Tax Court pointed out that there were no restrictions on the assets in the IRAs, because they were marketable securities. On the zoning and contamination issues, there were no costs to make the IRA assets more marketable; nor was there any contingent claim as there was in Estate of Algerine Smith. Finally, the Tax Court cited Estate of Louis Smith [391 F3d 621 (5th Cir. 2004)] as support for its ruling.

Drawing Distinctions

The Tax Court’s ruling provides a logical basis for determining if a reduction in value of assets that are in the gross estate will be allowed. If the reduction in value is passed on to the hypothetical willing buyer of an asset, then a reduction in value will be allowed in the gross estate. If the hypothetical willing seller bears the reduction in value, then a reduction will not be allowed. Under this logic, assets in IRAs will not be reduced in value. This ruling presumably applies to all retirement accounts subject to income tax when distributions are made from the accounts.