QCD and estate tax deduction

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  • #4942
    wanttoknow
    Participant

    I have a traditional inherited IRA from which I take RMDs, and each year I take an itemized deduction for the estate tax on income in respect of decedent.

    This year I am considering making a Qualified Charitable Distribution (QCD) with part of the RMD.

    Ten years ago on this forum I was told that the estate tax deduction cannot be taken for a QCD.

    Assuming that’s still true, would the following be the correct way to calculate the amount of the non-allowed estate tax deduction?

    QCD = 4.4% of RMD. So non-allowed estate tax deduction = 4.4% of estate tax deduction without QCD.

    #4953
    Alan S.
    Participant

    Yes, since a QCD is not included in gross income, the IRD deduction cannot be taken for QCD amounts and this operates in the same manner as if the inherited IRA included basis or was an inherited Roth IRA. Of course, this is moot unless you still itemize given the new higher standard deduction.

    As for the math, it would be more direct to figure the IRD deduction by just reducing the gross distribution by the amount of the QCD and plugging that figure into the formula outlined in Pub 559. I’m not sure whether that would generate a different figure than your proposed 4.4% reduction or not. Of course, once you have recovered the full IRD deduction, the deduction ends even if value remains in the inherited IRA.

    It is interesting to note how the QCD adjustment with respect to the deduction differs from NOT doing a QCD, being taxed on the distribution and then making an itemized taxable donation. The latter method would not reduce the IRD deduction, while the QCD would. The reduction of the distribution by the QCD amount is the same as if there was inherited basis in the IRA except that the QCD is triggered by you, while the basis was contributed by the decedent.

    Here is an interesting article from Kitces regarding the IRD deduction and in the middle of it he touches on inherited IRA RMDs and the effects of gains or losses on the IRD Deduction.

    https://www.kitces.com/blog/understanding-the-irc-section-691c-income-in-respect-of-a-decedent-ird-deduction-for-the-beneficiary-of-an-inherited-ira/

    • This reply was modified 1 week ago by Alan S..
    #4955
    wanttoknow
    Participant

    Thanks Alan,

    Is the formula to which you referred the one in Example 2 on page 13 of Pub. 559?

    https://www.irs.gov/pub/irs-pdf/p559.pdf

    “Value included in your income
    divided by Total value of income in respect of decedent
    times Estate tax qualifying for deduction”

    This seems to concern what portion of all deductible estate tax pertaining to an estate to allocate to a particular asset received by a particular beneficiary. For my inherited IRA the calculation of total IRD and total deductible estate tax, plus how that is divided up among multiple years of IRA distributions, was calculated many years ago.

    I don’t see how to apply this formula to determining the estate tax deduction on this year’s IRA distribution reduced by the QCD.

    Actually, taking the entire RMD and contributing 4.4% of it would be more advantageous income-tax-wise than doing a QCD with the estate tax deduction calculated the way I showed in my original post. I just didn’t know if that was the right way to do the calculation.

    #4960
    Alan S.
    Participant

    Yes, example 2. That example illustrates where a beneficiary received 12,000 in a year out of a total of 20,000 he had a right to receive. That fraction is multiplied by the amount of the decedent’s estate tax paid allocated to the amount the beneficiary inherited. The 4620 and the 20,000 figure was determined one time and remains fixed.

    Applied to your situation, the amount you distribute in a year (RMD or otherwise) will probably vary, so your IRD deduction would vary from year to year until it was fully claimed. However, the QCD amount will not be included in your income, so the amount you received should be reduced by the QCD amount. Say you inherited 1,000,000 of (taxable) IRD, and this year you are withdrawing 100,000 including a 4400 QCD. You would then claim an IRD deduction of 95,600/1,000,000 times the estate tax that the decedent paid on your share of the amount you inherited.

    Here is an article by Michael Kitces explaining the IRD deduction on an inherited IRA. https://www.kitces.com/blog/understanding-the-irc-section-691c-income-in-respect-of-a-decedent-ird-deduction-for-the-beneficiary-of-an-inherited-ira/

    See example 3 in the above article. Also, note that the IRS has not issued specific guidance on the handling of gains, and that also applies to QCDs, where you are actually receiving income the decedent would have been taxed on, but you are allowed to use a QCD to escape that tax. So it makes sense not to claim the IRD deduction on the amount you withdraw this year that was distributed as a QCD.

    #4963
    wanttoknow
    Participant

    Thanks, Alan.

    Now I understand how to use the formula in Example 2. However, that is radically inconsistent with how my estate tax deduction has been calculated over the past 15 years; and without the 4.4% QCD results in an estate tax deduction for this year more than four times the deduction according to the usual method, and 52% more than the remaining estate tax deduction.

    Example 2 method:
    $227,885 2019 distribution
    divided by $875,849 original IRD
    times $381,060 original estate tax deduction
    = $99,147 2019 estate tax deduction.

    Usual method: $23,228 2019 estate tax deduction.

    The formula I have used for the past 15 years divides the “unused” estate tax balance by the original divisor from Table I (17.8) minus 1 for each successive year. This means each year’s estate tax deduction has been the same.

    Any growth in the IRA has no effect on the annual estate tax deduction. In this respect my method is similar to the FIFO method described by Kitces.

    #4964
    Alan S.
    Participant

    Yes, it appears that your calculation understates the IRD deduction you have been entitled to for each year. Kitces’ FIFO method means that gains in the IRA that result in a larger distribution can still be treated as IRD, but only until the full IRD deduction has been recovered, which you actually might have fully recovered by now. With only a 23,228 annual IRD deduction, by the time the IRA is drained (another 3 years) you will only have recovered about half of the total deduction.

    Therefore, if you continue as is you will end up losing half the deduction. If you change methods now (or decide to amend 2016-2018) there is a chance the IRS could disallow the additional deduction you should have claimed for the first 12 years instead of allowing you to carry it forward. However, I would discount that possibility and amend those returns for a sizeable refund. The deduction will vary somewhat each year relative to the gross amount you distributed.

    Therefore, in very rough numbers if you recovered 23,000 for 12 years, that is around 276,000. For 2016-2019 if you average 95,000 per year that would bring your total to 656,000 recovered through 2019. The remaining amount of 220,000 (876,000-656,000) would nearly be fully recovered in 2020 and 2021.

    NOTE: I am assuming that the 381,000 “original estate tax deduction” (the one time determination) is correct. That figure should be the difference between the estate tax actually paid by the decedent less the estate tax the decedent WOULD HAVE paid had the inherited IRA not been included in the estate tax calculation. So this figure should be the estate tax attributed to your inherited IRA. I would be sure that figure is correct since it is the amount multiplied by the fraction each year since you started.

    It is fortunate that misc deductions NOT subject to the 2% AGI floor like the IRD deduction are still available.

    Obviously, recovery of your full IRD deduction over the remaining 3 years is a much larger issue than the minor affect of a small QCD. You probably should still NOT include the QCD amount in the 2019 calculation of your IRD Deduction. And of course for 2019 you would need to correctly report the QCD on line 4a and 4b to eliminate it from taxable income. The 1099R will include the QCD, so you need to subtract it on line 4.

    #4966
    wanttoknow
    Participant

    Thanks, Alan.

    But there has been a misunderstanding. $875,849 is the amount of original IRD, not the original estate tax deduction.

    The original estate tax deduction was $381,060, and $316,026 of that has already been included in itemized deductions over the past 15 years. (The fact that $316,026 doesn’t equal 15 x $23,228 is due to a couple of minor glitches, including no RMD in 2009.)

    The remaining $65,034, according to my normal method, would be deducted: $23,228 2019, $23,228 2020, $18,578 2021—when the IRA will be exhausted.

    However, it might be advantageous to accelerate the remaining deductions. Since you suggested increasing from $23,228 per year through 2015 to $95,000 per year from 2016, I’m thinking that even the most extreme acceleration—all of the remaining $65,034 deducted this year—would be possible, but with the associated risk that any disallowed excess might not be recoverable in 2020-21.

    Yes, the $381,060 original estate tax deduction was calculated as you describe.

    • This reply was modified 4 days, 1 hour ago by wanttoknow.
    #4970
    Alan S.
    Participant

    Yes, I grabbed IRD amount instead of the actual estate tax of 381,000, so you would still receive your total deduction by the time the IRA was drained the way you have been doing it. However, you could have deducted the estate tax at a faster rate by using the Pub 559 formula and the 2019 deduction would be nearly 100,000 using that formula.

    Since the method you have been using has never been questioned, you could be consistent and maintain that to the last year. If you report a drastically increased deduction for this year in proportion to your 1099R, it might trigger an inquiry. So could any amended returns you file for 2016-2018. However, now that it appears you would complete your deduction in about 3 years without losing any of the total deduction of 381,000, it may be better to stick with the method you have been using which still generates the correct total deduction, just at a much slower annual rate than you could have received it by using the Pub 559 formula.

    #4971
    wanttoknow
    Participant

    It seems to me that if the taxable amounts of successive annual IRA distributions are plugged into the formula in Example 2 of Pub. 559, this is the same as the FIFO method described by Kitces.

    With this method my estate tax deduction would have been exhausted in 2014. I’m not sure this would have been a good thing; it depends on what my marginal tax rates were (and will be) in various years.

    However, Pub. 559 says “If the amount you collected for the accounts receivable was more than $12,000, you would still claim $2,772 as an estate tax deduction because only the $12,000 actually reported on the estate tax return can be used in the above computation.” This indicates to me that the Pub. 559 formula is not meant to take into account any growth in the inherited IRA after death of the decedent.

    #4973
    Alan S.
    Participant

    You are correct. Had you used the Pub 559 formula from the start, you would have larger estate tax deductions each year, but more of that deduction would have offset your taxable income in lower brackets. A lower annual deduction is less likely to be applied to these lower brackets. Therefore, perhaps you just stay with your current method for consistency, even though it generates a lower deduction (and will therefore last more years) than the correct method in Pub 559.

    Re your last paragraph – yes you definitely cannot increase the total IRD above the amount you inherited, because that figure is limited by the estate tax return of the decedent. However, the FIFO theory is that the first dollars distributed from your inherited IRA do not have to be apportioned in some manner between subsequent investment gains and the original IRD amount, so you can treat your distribution as all IRD until the entire amount of IRD is applied to generate an estate tax deduction. This will accelerate the distribution of the IRD and in turn accelerate the estate tax deduction, but it will not increase the total amount of IRD or estate tax deduction available. Again, any apportionment or FIFO decision is based on the opinion of tax experts since no specific IRS guidance on these issues has been issued.

    Nor has there been direct guidance on QCD adjustments to the formula. Note that reducing the amount distributed by the QCD would have the same effect as if you inherited an IRA with basis from non deductible contributions (Form 8606 would be used to report the distribution), any IRA basis would be inherited by you. Conversely, a QCD is applied solely by you to reduce the taxable amount distributed. Not clear if the IRS would perceive some distinction between the QCD and inherited basis.

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