The Pennsylvania personal income tax treats “income in respect of a decedent” (often referred to as “IRD”) in a way that is completely different from the federal income tax treatment of IRD, and practitioners dealing with estates of Pennsylvania decedents should be aware of the difference.
“Income in respect of a decedent” is defined by I.R.C. section 691, and refers to money or property received after the death of a decedent which was not properly included in the decedent’s income during his or her lifetime, but would have been income to the decedent if received during the decedent’s lifetime. Typical examples of IRD include:
- Wages, salaries, and other compensation earned during lifetime but not paid until after death.
- Interest accrued during lifetime but not received until after death.
- Dividends payable to the shareholders of record as of a date before death but not actually paid until after death.
- Individual retirement accounts and other retirement plan benefits paid after death.
- Annuities that continue to be paid after death.
- Payments on notes or contracts that include capital gains being realized on an installment method.
Federal law is clear that items of IRD received by an estate or beneficiary are included in gross income and have the same character for federal income tax purposes as the items would have had in the hands of the decedent. But that is not the rule for Pennsylvania income tax purposes.
The Pennsylvania personal income tax applies to eight different classes of income, and income is taxable only if it falls within one of those eight classes. (By comparison, federal law taxes “all income from whatever source derived.”) It has always been clear from the definitions of those classes of income that at least some IRD was not included in those definitions, and so not taxed. For example, taxable “compensation” is defined as amounts received by an “employee,” and an estate receiving wages earned by a decedent is not an “employee.”
Currently, the Department of Revenue seems to take the position (see qualifications below) that nothing that is IRD is subject to income tax:
- The instructions to Form PA-40 for 2016 (but not the PA-41, for some reason) included a list of income not taxable, and included in the list is “Inheritances, death benefits, and income in respect of a decedent (IRD) as defined for federal income tax purposes.”
- Chapter 14 of the Pennsylvania Personal Income Tax Guide includes the following:
- In Part II.E.1.: “Federal Rules for Income in Respect of Decedent Not Controlling. Pennsylvania has no rule similar to that for federal income tax purposes that governs income in respect of a decedent.”
- In Part II.E.3.: “Amounts Taxable to Estate or Survivor. Any item of income or deduction that would have been reportable on the last return if the taxpayer had personally used the accrual method of accounting that is not reportable or deductible thereon using the cash basis method is taxable to, or deductible by, neither the decedent nor his estate, heirs or beneficiaries. For example, taxpayer earned a bonus as of December 31 payable on April 15, but taxpayer died on March 15. This income would not be taxable anywhere.” (Emphasis in original.)
- The instructions to Form PA-41 refers to “Pennsylvania income tax withheld on income in respect of a decedent (not taxable for estate or trust income tax purposes, but includable in the value of an estate for inheritance tax purposes)….”
Income in respect of a decedent should therefore be reported on the Pennsylvania inheritance tax return if otherwise included in a taxable transfer, and on a federal fiduciary income tax return (Form 1041), but should not be reported on a Pennsylvania fiduciary income tax return (Form PA-41) or an individual income tax return (Form PA-40).
The Pa. Department of Revenue may be changing its position on the taxation of IRD, because the instructions to Form PA-40 for 2017 were different from the instructions for 2016, discussed above.
- The instructions for PA-40 (for individuals) now includes the following statement about types of income that are NOT taxable: “Inheritances, death benefits, and income in respect of a decedent (IRD) as defined for federal income tax purpose for purposes of compensation (NOTE: IRD may be subject to the PA PIT in a class of income other than compensation).” The “for purposes of compensation” is new, as is the “note” in parentheses. But even the parenthetical says that IRD other than compensation “may” be subject to tax, and not “is” subject to tax.
- The PA-40 instructions also contain a cross-reference to the PA Personal Income Tax Guide, the on-line version of which was last revised on 8/24/2012, and continues to include the statements quoted above.
- More importantly, there is no similar change to the instructions to Form PA-41, for estates and trusts. Those instructions continue to state that compensation received post-death is not taxable, which is consistent with the PA-40 instructions. The only other reference to IRD is in instructions on withholdings, which refers to “income in respect of a decedent (not taxable for estate or trust income tax purposes, but includable in the value of an estate for inheritance tax purposes).”
There has therefore been a change to the instructions to Form PA-40, but no change to instructions for Form PA-41, and (more importantly), no change to the PA Personal Income Tax Guide. Whether the change in the PA-40 instructions represents the beginning of a change in policy, or a errant deviation, still isn’t clear.
However, the tax treatment of annuities may be less ambiguous. The “classes of income” subject to Pa. income tax include “any amount paid under contract of life insurance or endowment or annuity contract which is includable in gross income for Federal income tax purposes.” 72 P.S. 7303(a)(6). The literal application of that language would lead to the conclusion that annuity income is taxable for Pennsylvania purposes regardless of whether the federal taxation is derived from I.R.C. section 72 (annuities) or section 691 (income in respect of decedents).