9.7 Postmortem Planning Elections, Income in Respect of a Decedent & Intra-Family Loans

9.7 Postmortem Planning Elections, Income in Respect of a Decedent & Intra-Family Loans

Estate planning does not end at death. A substantial portion of the value an advisor adds to a wealthy family is delivered in the nine to fifteen months after a death, through elections that are available only during that window and are irrevocably lost when it closes.

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1. The Alternate Valuation Date — IRC §2032

The default is to value the gross estate at the date of death. An executor may instead elect to value it six months after death — with property distributed, sold, or otherwise disposed of during that period valued as of the disposition date.

The election is not freely available. Under §2032(c) it may be made only if it decreases both:

1. The value of the gross estate, and
2. The combined estate tax and generation-skipping transfer tax liability

This dual test defeats the intuitive maneuver. An executor of an estate below the basic exclusion amount — where no tax is due — cannot elect alternate valuation to capture a higher basis, because the election would not reduce a tax that is already zero. Nor can an executor of a taxable estate elect alternate valuation when values have risen, since that fails the first prong.

The election is all-or-nothing across the entire estate (an executor cannot cherry-pick assets) and is irrevocable.

The basis trade-off. Alternate valuation lowers the estate tax but also lowers the heirs' §1014 basis, converting a 40% estate tax saving into future capital gain taxed at 23.8%. For an estate holding assets the family intends to sell soon, the executor should model both outcomes rather than reflexively minimizing the estate tax.

Special use valuation under §2032A is a separate election for qualifying farm and closely held business real property, valuing it at actual use rather than highest-and-best use, subject to an inflation-adjusted reduction cap and a ten-year recapture period if the heirs cease qualified use.

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2. Qualified Disclaimers — IRC §2518

A disclaimer is a refusal to accept property. When it satisfies §2518, the disclaimant is treated as having predeceased — the property passes to the next taker with no gift from the disclaimant.

All five requirements must be met:

1. In writing, and signed
2. Delivered to the transferor, the legal representative, or the holder of title within nine months of the transfer (or of the disclaimant reaching age 21)
3. The disclaimant has not accepted the property or any of its benefits — including a single dividend, an RMD, or use of the residence
4. The property passes without any direction from the disclaimant
5. It passes either to the decedent's spouse or to a person other than the disclaimant

What disclaimers accomplish postmortem:

• A surviving spouse disclaims into a credit shelter trust, moving assets out of the survivor's estate when the first spouse's exclusion would otherwise go unused.
• A child disclaims, allowing property to pass to grandchildren and use the decedent's GST exemption.
• A beneficiary disclaims an inherited IRA to a charity, avoiding IRD entirely.
• An heir with creditor problems disclaims — though this is generally ineffective against a federal tax lien under Drye v. United States.

The fatal error is the fifth requirement: a spouse who disclaims into a trust over which she holds a general power of appointment has effectively directed the property to herself, and the disclaimer fails. A limited power of appointment, or a trust where the spouse is merely a discretionary beneficiary, preserves it.

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3. Other Postmortem Elections

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4. Income in Respect of a Decedent — IRC §691

IRD is income the decedent had a right to receive but had not yet recognized at death. Because it was never taxed to the decedent, it does not receive the §1014 basis step-up.

Common IRD items:

• Traditional IRA, 401(k), and 403(b) balances
• The gain portion of a non-qualified annuity
• Non-qualified deferred compensation
• Accrued but unpaid salary, bonuses, and commissions
• Installment note payments receivable
• Accrued interest on savings bonds
• Unrecognized net unrealized appreciation on employer stock (see §12.2)
• Renewal commissions

The double-tax problem. IRD is included in the gross estate at full value and taxed as ordinary income to the recipient. A $5,000,000 IRA in a taxable estate can face 40% estate tax and then ordinary income tax on distribution.

The §691(c) deduction is the partial remedy: the recipient may claim a miscellaneous itemized deduction not subject to the 2% floor for the federal estate tax attributable to the IRD. Compute it by determining the estate tax with the IRD included, recomputing without it, and deducting the difference proportionally as the IRD is recognized. The deduction is routinely missed by preparers, which makes flagging it a concrete piece of advisor value.

Planning responses:

• Name a charity as beneficiary of the IRD-heavy account and leave step-up-eligible assets to individuals. The charity pays no income tax, so the IRD burden vanishes entirely.
• Roth-convert during life — the conversion tax is paid from other assets, shrinking the estate and eliminating the IRD for heirs.
• Use qualified charitable distributions during life to drain the IRA (see §12.5).
• Where a spouse rolls over an IRA, the IRD is deferred, not eliminated.

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5. Intra-Family Loans

A loan between family members transfers all growth above the interest rate to the borrower without using any gift tax exclusion. Because the applicable federal rate is typically well below the expected return on the borrowed funds, the spread is a free wealth transfer.

The AFR and IRC §7872

The applicable federal rate is published monthly by the IRS in three tiers by term: short-term (up to 3 years), mid-term (over 3 up to 9 years), and long-term (over 9 years). Charging at least the AFR in effect for the month of the loan avoids imputed interest entirely, and the rate for a fixed-rate term loan is locked at inception.

If the loan bears below-AFR interest, §7872 recharacterizes the foregone interest as a gift from lender to borrower and as interest income back to the lender. Two exceptions matter:

• $10,000 de minimis exception — gift loans between individuals of $10,000 or less are exempt, provided the proceeds are not used to buy income-producing assets.
• $100,000 exception — for gift loans of $100,000 or less, imputed interest is capped at the borrower's net investment income, and is zero if that income does not exceed $1,000.

Making the Loan Respected

1. A written promissory note stating principal, the AFR-based rate, the payment schedule, and maturity
2. Actual payments actually made, and deposited
3. Security where the amount warrants it — a mortgage on real property, a pledge of securities
4. Documented ability to repay at inception
5. Enforcement if payments are missed; a lender who never pursues default invites recharacterization as a gift
6. Lender reports the interest income; borrower deducts only if the tracing rules in §5.6 permit

Common Applications

• Home purchase: a mid-term AFR loan far below a commercial mortgage rate, secured by the residence so the borrower may deduct qualified residence interest.
• Business capitalization: funding a child's venture without diluting equity.
• Refinancing a child's high-rate debt at the AFR.
• Loan to a grantor trust: the interest is a non-event under Rev. Rul. 85-13 (see §9.4).
• Forgiveness: forgiving principal is a gift in the year forgiven and can be sheltered by annual exclusions, but a pre-arranged plan of systematic forgiveness invites the IRS to treat the original transfer as a gift from the start.

Exam Trap. Any loan that is not documented, not secured, not repaid, and never enforced is a gift, regardless of what the parties call it. The substance-over-form analysis looks at behavior after the money moves, not at the label on the transfer.