Loan Receivable - IRD question

[Nashville]

Mortimer makes a 10-yr loan for which no payments are due until the 5th year. Just so we'll have a quantitative example, let's assume the amount to be $100,000 at 5% interest. Mortimer dies, late in Year 4 of the loan, and there is $21,550 in interest now tacked on to the loan which he has never received nor reported as income.

Question, do his beneficiaries inherit the Receivable at a stepped-up basis of $121,550? Or do they inherit a Receivable of $100,000 with $21,550 which must be taken into income as it is received? (Is the interest effectively "Income in Respect of a Decedent")

Does the answer change if he has loaned the money to his 100%-owned S Corp? (all other factors are the same - no payments and $21,550 interest calculated at time of death in yr 4)

If you take time to share your answer with me, please assume the given facts and do not introduce other factors or terms into the given situation (unless you feel I have blatantly ignored something very important).

[Maribeth]

Just started the first session of a 3 session 1041 class through NATP today.

From the slides of the class: "Installment sale payments from sales made prior to death" are IRD. You don't have a sale with your obligation but you do have an installment receivable. I believe the logic would be the same and your contract is IRD, including the unpaid interest payments.

[Roland Slugg]

The receivable/loan and the accrued interest thereon are, in a sense, two separate assets. Someone who inherits "income" never gets a stepped-up basis in that income. The income simply remains income to the person who receives it. The accrued interest to the DOD will indeed be IRD, but that label is only relevant if an estate tax return was required to be filed and estate tax was paid. In that case IRD can result in a deduction on the beneficiary's own tax return when he receives that accrued interest. The deduction for IRD is usually quite small, and it's deductible on Schedule A (Form 1040) as a "Miscellaneous Itemized Deduction" not subject to the 2% haircut.

The loan itself is another matter. Its basis in the hands of the person who inherits it is its FMV as of the decedent's death. That value might be higher, lower or equal to the $100,000 face value in your example. It all depends on the loan's collectibility, marketability and, perhaps, other factors. If it is valued at less than its face value, then any excess later collected would be income in addition to all the interest being income as well. If the decedent were my client, I would value the receivable at its face value ... $100K ... in almost all cases, unless there was clear evidence that it was worth less.

If the funds were loaned to the decedent's 100%-owned S Corp, nothing changes. The S-Corp's stock is simply another asset to be valued when passed on to the decedent's beneficiary(ies). Of course in valuing the S Corp's shares, the loan and accumulated interest thereon would need to be taken into account in making that valuation. In any case, the loan and accruing interest would remain liabilities to that corp.