The estate tax deduction deals with items of Income in Respect of Decedent (IRD). Income in Respect of Decedent items can be subject to both the estate tax and an income tax. The estate tax deduction compensates for this double taxation on IRD items. Pensions, IRAs, final wages, and property sales are often subject to estate tax deductions.
The estate tax deduction is the difference between the estate tax including IRD items and the estate tax without IRD items.
An estate often has, as an asset, the right to receive items of income on which income tax has yet to be paid. Those income items are called Income in Respect of Decedent. If the estate is large enough to pay an estate tax, the Income in Respect of Decedent items are taxed twice:
Estate tax, a tax on the transfer of property
Income tax, a tax on the receipt of income
To compensate for this double taxation, Congress has instituted the estate tax deduction.
The types of IRD that most commonly trigger the estate tax deduction are pensions and IRAs, final wages, and the sale of property. The sale of property can be subject to the estate tax deduction in the following cases:
The property is undergoing an ongoing installment sale.
The decedent dies after the purchase and sale agreement is signed, but prior to the actual property transfer.
If you’re administering a large estate and have paid an estate tax, you may be entitled to a deduction on the estate or trust’s income tax return (on Form 1041, line 19) for the portion of estate taxes paid on these IRD items.
To determine the estate tax deduction:
First, calculate the estate tax based on the value of the total estate, including IRD.
Then calculate the estate tax a second time on the value of the estate without IRD.
The difference in the two calculations is the amount of estate tax paid on that piece of income. This is the amount of your estate tax deduction.