Most baby boomers, who are now between the ages of 42 and 60, will soon face two major events in their lives: planning for retirement and the death of their parents. Many of these individuals will take on the role of personal representative (executor) of their parents’ estates when their parents die and will receive compensation from the estate for these services. From a tax standpoint, how is this income taxed? Is it considered self-employment (SE) income subject to both SE tax and income tax? Can this compensation be claimed as earned income for the purposes of contributing to an IRA?
According to Regs. Sec. 1.1402(c)-1, a taxpayer must carry on a trade or business, either as an individual or as a member of a partnership, in order to have net SE earnings. According to Rev. Rul. 58-5:
Generally, nonprofessional fiduciaries (that is, for example, persons who serve as executor or administrator in isolated instances, and then as personal representative for the estate of a deceased friend or relative) will not be treated as receiving income from a trade or business unless all of the following conditions are met:
(a) There is a trade or business among the assets of the estate,
(b) The executor actively participates in the operation of this trade or business,
(c) The fees of the executor are related to the operation of the trade or business.
However, according to Rev. Rul. 58-5, in some circumstances, even though the estate’s assets do not include a trade or business, if the management activities required of the executor for administering the estate are sufficient in scope and duration, these activities could constitute operation of a trade or business and the income be deemed SE income.
In Rev. Rul. 72-86, the IRS distinguished between the SE treatment of the fees paid to executors and fees paid to persons serving in a fiduciary capacity as members of a corporation’s board of directors. According to the IRS, the fees received from a corporation for performing services as a board director are SE income because the individual’s work is on a regular and continuous basis and is based on that individual’s qualities or expertise. The Service stated that fees paid to a nonprofessional executor or personal representative (except in certain circumstances) are not SE because the services are performed on an isolated basis and stem from a personal relationship with the decedent that is not based on particular expertise or special qualities.
The IRS summarizes its position on fees received by nonprofessional executors or personal representatives in Publication 559, Survivors, Executors, and Administrators:
All personal representatives must include in their gross income fees paid to them from an estate. If paid to a professional executor or administrator, self-employment tax also applies to such fees. For a nonprofessional executor or administrator (a person serving in such capacity in an isolated instance, such as a friend or relative of the decedent), self-employment tax only applies if a trade or business is included in the estate’s assets, the executor actively participates in the business, and the fees are related to operation of the business.
Contributions to an IRA are allowable if a taxpayer has compensation and it is includible in his or her gross income for the year (Sec. 219(b)). Under Sec. 219(f), compensation is defined as earned income under Sec. 401(c)(2). This term means earnings from self-employment with respect to a trade or business in which personal services of the taxpayer are a material income-producing factor. It appears, then, that nonprofessional executors or personal representatives who handle estates without trade or business assets cannot be deemed to be in a business themselves. Thus, the fees received by these individuals are not subject to SE tax and are not earned income for IRA contribution purposes.
According to current tax law, fees received for personal services performed in operating a trade or business are subject to SE tax and are allowed as earned income for purposes of contributing to an IRA. The IRS generally does not consider fees received as nonprofessional executors or personal representatives to fall into this category. The main reasons cited are lack of (1) continuing services and (2) special qualities or expertise. However, being a nonprofessional executor or personal representative does involve a considerable amount of time and effort. The individual usually is involved in taking an inventory and marshalling the assets of the estate, meeting with an attorney, making investment decisions, selling the principal residence, and distributing the assets to the beneficiaries.
The treatment of the fees paid to nonprofessional personal representatives is seemingly out of step with the federal government’s policies regarding retirement savings. For example, the recently enacted Heroes Earned Retirement Opportunities Act, P.L. 109-227, allows military personnel who receive tax-free combat pay to count it as earned income for IRA contribution purposes. Previously, this pay was not deemed earned income because it was not includible in gross income. Moreover, the federal government encourages taxpayers to save for and fund retirement so they will not be dependent on the government for support during retirement. Arguably, both government and taxpayer interests could be furthered if taxpayers, depending on their particular situations, could either pay SE tax and contribute to an IRA or choose not to do so.