Adjusting Basis of Inherited S Stock for IRD

Editor: Albert B. Ellentuck, Esq.

Income in respect of a decedent (IRD) generally consists of items of gross income a decedent was entitled to at death that, because of the decedent’s method of accounting, were not included in the final individual return; see Regs. Sec. 1.691(a)-1(b). IRD is included in a decedent’s assets on the estate tax return and, when received, is includible in the income of the person or entity acquiring the right to receive it (i.e., the beneficiary). Some of the more common items that may be IRD include interest and dividend income from an S corporation’s investments and income from installment sales made by an S corporation. Further, a cash-method professional practice will always have IRD in the form of its accounts receivable, as these represent an asset to the decedent and are also income under the cash method of accounting when subsequently collected.

S Stock Issues

A person acquiring S stock from a decedent treats as IRD his or her pro-rata share of income items that would have been IRD had the items been acquired directly from the decedent. To mitigate the fact that the income has been included in the estate and is taxable to the beneficiary as well, the beneficiary deducts the Federal estate tax attributable to the IRD as a miscellaneous itemized deduction, not subject to the 2%-of-adjusted-gross-income (AGI) limit; see Sec. 691(c).

Example

Robert owns 50% of the shares of Rib, Inc., a calendar-year S corporation. Rib is on the cash basis and holds a $400,000 note receivable that bears interest at 10%, payable annually. Robert died on Dec. 31, 2005, the day before the $40,000 annual interest payment was due. The $40,000 of interest accrued but not paid at Robert’s death is IRD.

Wanda inherits Robert’s Rib stock, and for the year ended Dec. 31, 2006, Rib passes through $20,000 ($40,000 × 50%) of interest income received on the note to her. Robert’s estate paid $7,000 additional estate tax because the $20,000 accrued interest was included on his estate tax return. Wanda reports the $20,000 as interest income on her Form 1040 and deducts the $7,000 on Schedule A under “Other Miscellaneous Deductions” (not subject to the 2%-of-AGI limit).

Basis

The stepped-up basis in S stock acquired from a decedent is reduced to the extent the stock’s value is attributable to items consisting of IRD, under Sec. 1367(b)(4). The accumulated adjustments account is also reduced by the IRD items.

Planning tip: Sec. 1367(b)(4)(B) states that the basis of inherited S stock is reduced by “the portion of the value of the stock which is attributable to items constituting income in respect of the decedent.” This does not necessarily mean that basis is reduced dollar-for-dollar by IRD if it can be established that the presence of IRD does not increase the stock’s overall value, dollar-for-dollar. Thus, the stock’s value should be determined twice—once with the IRD items included in the calculation and once with the IRD items excluded. The difference between the two calculations yields the portion of the value of the stock attributable to IRD items.

This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 20th Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, James A. Keller and Diana L. Stephens, published by Practitioners Publishing Company, Ft. Worth, TX, 2006 ((800) 323-8724; ppc.thomson.com).