TAXATION of INCOME of DECEDENTS George Craven T

1953] TAXATION OF INCOME OF DECEDENTS George Craven t The federal income tax statute dealing with income in respect of decedents 1 has been in force for eleven years, and during that period the courts have solved many of the income tax problems arising under that statute as well as companion problems arising under the estate tax statute. As an aid to understanding the purpose and meaning of the income tax statute, it is helpful to review the considerations which gave rise to its enactment. TREATMENT PRIOR TO 1942 OF INCOME ACCRUED AT DEATH Prior to the Revenue Act of 1934, if an individual filed his federal income tax returns on a cash basis, income which had accrued to him but was uncollected at the time of his death was not taxable to the decedent, because it had not been received by him. It was subject to estate tax as an asset of his estate, and it was held to be corpus and not income to the estate and therefore not subject to income tax to the estate2 The result was that the income escaped income tax entirely. The Revenue Act of 1934 provided for the first time for including in the final return of a cash basis decedent amounts of income accrued but uncollected at the time of death.' Similarly, that Act allowed as deductions in such decedent's final income tax return items other- wise deductible which had accrued but were unpaid at the time of his death.4 Those provisions remained in force until the enactment of the Revenue Act of 1942. The statute as amended in 1934 was found to operate inequitably against decedents. Although it was designed merely to prevent accrued income from escaping income tax and to allow certain deductions accrued at death,5 the statute as construed by the courts in cer- j- A.B., LL.B., Mercer University; Member of Georgia, Florida, New York and Pennsylvania Bars. 1. INT. REv. CODE § 126, as added by the Revenue Act of 1942, § 134, 56 STAT. 830 (1942). 2. Nichols v. United States, 64 Ct. Cl. 241 (1927), cert. denied, 277 U.S. 584 (1928); William G. Frank, 6 B.T.A. 1071 (1927); G.C.M. 8826, IX-2 Cum. BULL. 194 (1930). 3. Revenue Act of 1934, § 42, 48 STAT. 694 (1934). 4. Revenue Act of 1934, § 43, 48 STAT. 694 (1934). 5. H.R. REP. No. 704, 73d Cong., 2d Sess. 24 (1934) ; SEN. REP. No. 558, 73d Cong., 2d Sess. 28 (1934). See Helvering v. Enright, 312 U.S. 636, 639 (1941). (185) 186 UNIVERSITY OF PENNSYLVANIA LAW REVIEW [Vol. 102 tain cases caused large amounts to be taxed in a decedent's final return. For example, in Helvering v. Enright,' involving the final income tax return of a deceased member of a law firm, it was held that the return should include not only the decedent's share of legal fees accrued to the partnership in an accounting sense, but also his esti- mated share of fees which the firm had earned on uncompleted legal matters, where it was possible to determine the value of the services on a quantum meruit basis. It was so held even though the partnership was on a cash basis. The court said: "Accruals here are to be construed in furtherance of the intent of Congress to cover into income the assets of decedents, earned during their life and unreported as income, which on a cash return, would appear in the estate returns." 7 There was a similar decision in a companion case involving a deceased member of a medical partnership.8 The result in many cases was to pyramid or "bunch up" in a decedent's final return a large amount of income, some of which might never be collected by his estate. On the other hand, where a decedent's estate settled litigation pending at the time of his death and made a payment which would have been deductible as a business expense if made by the decedent, it was held that the amount was not deductible in the decedent's final return because the amount of the liability was not known or admitted at the time of death.' SECTION 126 When the Revenue Bill of 1942 was being considered by Con- gress, the Treasury Department recommended an amendment to the income tax law to eliminate the "bunching up" of income in a decedent's final return which resulted from the decision in the Enright case.10 It was suggested that, in order to avoid this hardship, Congress abolish the method then in force of taxing such income and that it substitute a *method which "taxes the income to the persons who actually receive it," that is, "to the estate or to the heir or legatee as the case may be." " Congress adopted the changes suggested by the Treasury Department in order to continue to subject such accrued 6. 312 U.S. 636 (1941). 7. Id. at 644-5. 8. Pfaff v. Comm'r, 312 U.S. 646 (1941). 9. Comm'r v. United States Trust Co., 143 F.2d 243 (2d Cir.), cert. denied, 323 U.S. 727 (1944). 10. See statement of Randolph E. Paul, Tax Adviser to the Secretary of the Treasury, Hearings before Committee on Ways and Means on H.R. 7378, 77th Cong., 2d Sess. 89 (1942). See also 2 MERTENS, LAW OF FEDERAL INCOME TAXA- TION § 12.100 (Supp. 1953). 11. Hearings,supra note 10. 1953] TAXATION OF INCOME OF DECEDENTS income to income tax but to grant relief from hardships resulting in 2 many cases from including such income in the decedent's final return.1 The change suggested by the Treasury Department was accom- plished by Section 134 of the Revenue Act of 1942, which struck out the provisions including accrued income and allowing accrued deductions in the final return of a cash basis decedent 13 and which added to the Internal Revenue Code a new Section 126, setting forth the rules for taxing such income. General Statutory Plan Section 126 abandons the terms "accrued income" and "accrued deductions" and uses instead the terms "income in respect of a decedent" and "deductions in respect of a decedent." The pattern of the statute is to tax such items of gross income, in the year in which they are actually received, (A) to the decedent's estate, if it acquires from the decedent the right to such income; (B) if such right is not acquired by the estate, to the person who acquires such right by reason of the decedent's death; or (C) if the estate acquires such right from the decedent and subsequently distributes it to an individual, to such individual who subsequently receives the income. 4 For example, if the decedent leaves as part of his general or residuary estate a bond on which interest of $100 was accrued at the time of death and the interest is received by his estate after his death, the accrued interest is taxable as income to the estate. If the bond is bequeathed specifically to a named legatee, the accrued income is taxable to the legatee in the year in which received. If the bond forms part of the estate passing to the executors, and before the interest is received the executors dis- tribute the bond to a general or residuary legatee, the interest is taxable to the legatee when received by him.'5 If a right to receive an item of "income in respect of a decedent" is transferred by sale, exchange or other disposition by the estate or 12. H.R. REP. No. 2333, 77th Cong., 2d Sess. 83 (1942); SEN. REP. No. 1631, 77th Cong., 2d Sess. 100 (1942). 13. INT. REV. CODE §§ 42, 43. 14. INT. REv. CODE §126(a) (1). 15. The provisions of § 126 are applicable to years beginning after December 31, 1942. (Revenue Act of 1942, § 134(f), 56 STAT. 832 (1942)). However, in cases where the decedent's final taxable period began after December 31, 1933, and before January 1, 1943, an option was afforded to the decedent's personal representative and the beneficiaries of his estate to elect to have items of income and deductions accrued at the time of death excluded from the decedent's final return and included in the returns of the estate or beneficiaries under the provisions of § 126. (Revenue Act of 1942, § 134(g), 56 STAT. 832 (1942)). Provision was made for the refund of taxes paid on the decedent's final return in cases where the election was exercised in the manner prescribed by statute. (Revenue Act of 1942, § 134(g), 56 STAT. 832 (1942)) ; U.S. Treas. Reg. 111, §29.126-4 (1943)). The latest date under the regulations for exercising such election was January 1, 1944. (U.S. Treas. Reg. 111, §29.126-4(b) (1943)). 188 UNIVERSITY OF PENNSYLVANIA LAW REVIEW [Vol. 102 individual who acquires such right from the decedent, there is includible in the income of the estate or individual in the year in which the transfer is made the fair market value of such right at the time of the transfer plus the amount by which any consideration for the transfer exceeds such fair market value."0 If, then, the right is sold for an amount in excess of its fair market value, the entire amount so received will be includible in the gross income of the transferor. The regulations state that if the right to receive such income is dis- posed of "by gift or bequest" by the person acquiring the right from the decedent, the fair market value of the right at the time of such disposition must be included in the gross income of the donor or testator.Y However, a distribution of such right by the estate or trust to a specific legatee or a residuary legatee or by a testamentary trust to a remainderman is not considered a transfer which causes the value of the right to be includible in the income of the estate or trust.' The Commissioner has ruled that where the widow of a deceased life insurance agent acquired from her husband the right to receive renewal commissions and she died before receiving the full amount of the commissions, the value of the uncollected portion was not includible in her final return.

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