sts are taxed at a higher rate in any event. For example, an estate or trust is taxed at 35% for every dollar of taxable income in excess of $2,519, whereas an individual is taxed at 35% only for taxable income in excess of $326,450.

Fortunately, there is a way around this problem. Under the tax laws, estates and trusts are treated as pass-through entities. That is, they are taxable entities, but only to the extent they actually hold taxable income. To the extent they pass their taxable income out to the beneficiaries in the year in which it is earned, they receive a corresponding dollar-for-dollar deduction. In that case, the beneficiaries pay the tax on the income instead of the estates or trusts.

So, if the estate - in our hypothetical - redeems the bonds and distributes the proceeds to the beneficiaries in the same year, then the estate won't pay a tax on the accrued interest. Instead, each of the beneficiaries will report the accrued interest, pro rata, on their respective tax returns.

Going back to our hypothetical again, let's assume that the estat

Question: Thank you so much for your response. It was over and above what I needed to know, which is great. The more informed we are on this the better!

I do have one additional question. If we cash out the bonds with the estate, the interest will be around $300,000.00. If we cash them out individually (split 3 ways), won't the taxes be lower as they will be under $150,000.00 (including our other income) for each of us and in a much lower tax bracket? I am not clear on the advantages of cashing them out in the estate. Please explain this further. Thank you, R.

Answer: Dear R. - Your follow-up question raises some important issues that do need to be addressed - and understood - when making distributions from an estate or trust.

From your original question, you stated that your grandmother left bonds worth roughly $600,000 and that those bonds would be distributed equally to the three of you. So, each of you will receive an inheritance of roughly $200,000.

The problem I was alluding to is this: All three of you expect to receive the same amount from your grandmother's estate. However, in determining whether all three of you receive the "same amount," you should not look at the gross amount distributed to each of you, you should look at the net amount distributed to each of you after all taxes have been paid on the distributions. This is especially true when there is a significant amount of income in respect of a decedent (IRD) involved, as there is in this case.

Here's a simple example that will help explain the problem. Let's assume that there are three bonds, each with a face value of $200,000. Bond A has no accrued interest; bond B has accrued interest of $100,000; and bond C has accrued interest of $200,000. The estate distributes bond A to your sister, bond B to your brother, and bond C to you. All three of you are in the 30% tax bracket, and all three of you redeem your bonds in 2006.

While all three of you received the face amount of $200,000, your net amount, after-tax, is not the same. Your sister's net amount is $200,000 because her bond had no accrued interest. Your brother's net amount is $170,000 because his bond had accrued interest of $100,000, which resulted in a $30,000 tax liability. Your net amount is $140,000 because your bond had accrued interest of $200,000, which resulted in a $60,000 tax liability.

If this were an actual case scenario, you can bet that there would be some unhappy campers here - and who can blame them? This result doesn't have to happen. And, it won't as long as the person in charge of making the distributions (i.e., the personal representative of the estate) is aware of this problem and takes the time to correct it.

How should distributions be handled in a case like this? Understand, first, that it's very difficult to equalize distributions of property when IRD is involved. Your grandmother, for example, probably had a good number of bonds, each purchased at different times and each with different amounts of accrued interest. Sure, you can equalize the face amounts easily enough, but you probably will find it very difficult to give each beneficiary the same amount of accrued interest.

A better way to handle these types of distributions is to have the estate liquidate the bonds and then distribute the cash proceeds to the beneficiaries. Let's see how this works with the hypothetical we used earlier. Remember, we assumed that your grandmother had three bonds: bond A with no accrued interest, bond B with accrued interest of $100,000, and bond C with accrued interest of $200,000. If the estate cashed in these bonds, it would have taxable interest of $300,000, which it would have to report on its tax return (Form 1041). Assuming the estate didn't distribute the money in the year the bonds were redeemed, the estate would then pay a tax on the accrued interest of roughly 35%.

While this course of action has the benefit of equalizing the net, after-tax, distributions to each beneficiary, there is a slight down-side in that the total taxes paid on the accrued interest will be higher than if the tax was paid directly by the beneficiaries. That's because (1) you lose the lower tax brackets available through income-splitting when the taxes are paid by the beneficiaries and (2) estates and trusts are taxed at a higher rate in any event. For example, an estate or trust is taxed at 35% for every dollar of taxable income in excess of $2,519, whereas an individual is taxed at 35% only for taxable income in excess of $326,450.

Fortunately, there is a way around this problem. Under the tax laws, estates and trusts are treated as pass-through entities. That is, they are taxable entities, but only to the extent they actually hold taxable income. To the extent they pass their taxable income out to the beneficiaries in the year in which it is earned, they receive a corresponding dollar-for-dollar deduction. In that case, the beneficiaries pay the tax on the income instead of the estates or trusts.

So, if the estate - in our hypothetical - redeems the bonds and distributes the proceeds to the beneficiaries in the same year, then the estate won't pay a tax on the accrued interest. Instead, each of the beneficiaries will report the accrued interest, pro rata, on their respective tax returns.

Going back to our hypothetical again, let's assume that the estate

our grandmother's estate. However, in determining whether all three of you receive the "same amount," you should not look at the gross amount distributed to each of you, you should look at the net amount distributed to each of you after all taxes have been paid on the distributions. This is especially true when there is a significant amount of income in respect of a decedent (IRD) involved, as there is in this case.

Here's a simple example that will help explain the problem. Let's assume that there are three bonds, each with a face value of $200,000. Bond A has no accrued interest; bond B has accrued interest of $100,000; and bond C has accrued interest of $200,000. The estate distributes bond A to your sister, bond B to your brother, and bond C to you. All three of you are in the 30% tax bracket, and all three of you redeem your bonds in 2006.

While all three of you received the face amount of $200,000, your net amount, after-tax, is not the same. Your sister's net amount is $200,000 because her bond had no accrued interest. Your brother's net amount is $170,000 because his bond had accrued interest of $100,000, which resulted in a $30,000 tax liability. Your net amount is $140,000 because your bond had accrued interest of $200,000, which resulted in a $60,000 tax liability.

If this were an actual case scenario, you can bet that there would be some unhappy campers here - and who can blame them? This result doesn't have to happen. And, it won't as long as the person in charge of making the distributions (i.e., the personal representative of the estate) is aware of this problem and takes the time to correct it.

How should distributions be handled in a case like this? Understand, first, that it's very difficult to equalize distributions of property when IRD is involved. Your grandmother, for example, probably had a good number of bonds, each purchased at different times and each with different amounts of accrued interest. Sure, you can equalize the face amounts easily enough, but you probably will find it very difficult to give each beneficiary the same amount of accrued interest.

A better way to handle these types of distributions is to have the estate liquidate the bonds and then distribute the cash proceeds to the beneficiaries. Let's see how this works with the hypothetical we used earlier. Remember, we assumed that your grandmother had three bonds: bond A with no accrued interest, bond B with accrued interest of $100,000, and bond C with accrued interest of $200,000. If the estate cashed in these bonds, it would have taxable interest of $300,000, which it would have to report on its tax return (Form 1041). Assuming the estate didn't distribute the money in the year the bonds were redeemed, the estate would then pay a tax on the accrued interest of roughly 35%.

While this course of action has the benefit of equalizing the net, after-tax, distributions to each beneficiary, there is a slight down-side in that the total taxes paid on the accrued interest will be higher than if the tax was paid directly by the beneficiaries. That's because (1) you lose the lower tax brackets available through income-splitting when the taxes are paid by the beneficiaries and (2) estates and trusts are taxed at a higher rate in any event. For example, an estate or trust is taxed at 35% for every dollar of taxable income in excess of $2,519, whereas an individual is taxed at 35% only for taxable income in excess of $326,450.

Fortunately, there is a way around this problem. Under the tax laws, estates and trusts are treated as pass-through entities. That is, they are taxable entities, but only to the extent they actually hold taxable income. To the extent they pass their taxable income out to the beneficiaries in the year in which it is earned, they receive a corresponding dollar-for-dollar deduction. In that case, the beneficiaries pay the tax on the income instead of the estates or trusts.

So, if the estate - in our hypothetical - redeems the bonds and distributes the proceeds to the beneficiaries in the same year, then the estate won't pay a tax on the accrued interest. Instead, each of the beneficiaries will report the accrued interest, pro rata, on their respective tax returns.

Going back to our hypothetical again, let's assume that the estat

0 because his bond had accrued interest of $100,000, which resulted in a $30,000 tax liability. Your net amount is $140,000 because your bond had accrued interest of $200,000, which resulted in a $60,000 tax liability.

If this were an actual case scenario, you can bet that there would be some unhappy campers here - and who can blame them? This result doesn't have to happen. And, it won't as long as the person in charge of making the distributions (i.e., the personal representative of the estate) is aware of this problem and takes the time to correct it.

How should distributions be handled in a case like this? Understand, first, that it's very difficult to equalize distributions of property when IRD is involved. Your grandmother, for example, probably had a good number of bonds, each purchased at different times and each with different amounts of accrued interest. Sure, you can equalize the face amounts easily enough, but you probably will find it very difficult to give each beneficiary the same amount of accrued interest.

A better way to handle these types of distributions is to have the estate liquidate the bonds and then distribute the cash proceeds to the beneficiaries. Let's see how this works with the hypothetical we used earlier. Remember, we assumed that your grandmother had three bonds: bond A with no accrued interest, bond B with accrued interest of $100,000, and bond C with accrued interest of $200,000. If the estate cashed in these bonds, it would have taxable interest of $300,000, which it would have to report on its tax return (Form 1041). Assuming the estate didn't distribute the money in the year the bonds were redeemed, the estate would then pay a tax on the accrued interest of roughly 35%.

While this course of action has the benefit of equalizing the net, after-tax, distributions to each beneficiary, there is a slight down-side in that the total taxes paid on the accrued interest will be higher than if the tax was paid directly by the beneficiaries. That's because (1) you lose the lower tax brackets available through income-splitting when the taxes are paid by the beneficiaries and (2) estates and trusts are taxed at a higher rate in any event. For example, an estate or trust is taxed at 35% for every dollar of taxable income in excess of $2,519, whereas an individual is taxed at 35% only for taxable income in excess of $326,450.

Fortunately, there is a way around this problem. Under the tax laws, estates and trusts are treated as pass-through entities. That is, they are taxable entities, but only to the extent they actually hold taxable income. To the extent they pass their taxable income out to the beneficiaries in the year in which it is earned, they receive a corresponding dollar-for-dollar deduction. In that case, the beneficiaries pay the tax on the income instead of the estates or trusts.

So, if the estate - in our hypothetical - redeems the bonds and distributes the proceeds to the beneficiaries in the same year, then the estate won't pay a tax on the accrued interest. Instead, each of the beneficiaries will report the accrued interest, pro rata, on their respective tax returns.

Going back to our hypothetical again, let's assume that the estat

s of distributions is to have the estate liquidate the bonds and then distribute the cash proceeds to the beneficiaries. Let's see how this works with the hypothetical we used earlier. Remember, we assumed that your grandmother had three bonds: bond A with no accrued interest, bond B with accrued interest of $100,000, and bond C with accrued interest of $200,000. If the estate cashed in these bonds, it would have taxable interest of $300,000, which it would have to report on its tax return (Form 1041). Assuming the estate didn't distribute the money in the year the bonds were redeemed, the estate would then pay a tax on the accrued interest of roughly 35%.

While this course of action has the benefit of equalizing the net, after-tax, distributions to each beneficiary, there is a slight down-side in that the total taxes paid on the accrued interest will be higher than if the tax was paid directly by the beneficiaries. That's because (1) you lose the lower tax brackets available through income-splitting when the taxes are paid by the beneficiaries and (2) estates and trusts are taxed at a higher rate in any event. For example, an estate or trust is taxed at 35% for every dollar of taxable income in excess of $2,519, whereas an individual is taxed at 35% only for taxable income in excess of $326,450.

Fortunately, there is a way around this problem. Under the tax laws, estates and trusts are treated as pass-through entities. That is, they are taxable entities, but only to the extent they actually hold taxable income. To the extent they pass their taxable income out to the beneficiaries in the year in which it is earned, they receive a corresponding dollar-for-dollar deduction. In that case, the beneficiaries pay the tax on the income instead of the estates or trusts.

So, if the estate - in our hypothetical - redeems the bonds and distributes the proceeds to the beneficiaries in the same year, then the estate won't pay a tax on the accrued interest. Instead, each of the beneficiaries will report the accrued interest, pro rata, on their respective tax returns.

Going back to our hypothetical again, let's assume that the estat

sts are taxed at a higher rate in any event. For example, an estate or trust is taxed at 35% for every dollar of taxable income in excess of $2,519, whereas an individual is taxed at 35% only for taxable income in excess of $326,450.

Fortunately, there is a way around this problem. Under the tax laws, estates and trusts are treated as pass-through entities. That is, they are taxable entities, but only to the extent they actually hold taxable income. To the extent they pass their taxable income out to the beneficiaries in the year in which it is earned, they receive a corresponding dollar-for-dollar deduction. In that case, the beneficiaries pay the tax on the income instead of the estates or trusts.

So, if the estate - in our hypothetical - redeems the bonds and distributes the proceeds to the beneficiaries in the same year, then the estate won't pay a tax on the accrued interest. Instead, each of the beneficiaries will report the accrued interest, pro rata, on their respective tax returns.

Going back to our hypothetical again, let's assume that the estate redeems the three bonds in 2006. It now has $600,000 in cash, but it also has accrued interest of $300,000, which it reports on its Form 1041. If the estate then distributes $200,000 to each of you, it will be deemed to have distributed the entire $300,000 of accrued interest to each of you equally; i.e., $100,000 to each of you. In that case, the estate will be entitled to a deduction of $300,000 on its tax return, which completely eliminates any tax liability on the part of the estate.

Each of you will then be required to report your pro rata share of the $300,000 in accrued interest on your respective tax returns for 2006. You'll know to do this because the estate will send you a Form K-1 (Beneficiaries Share of Income, Deductions, Credits, Etc.) at the end of the year.

The net result is that each of you will receive the same inheritance from your grandmother. You'll each receive a distribution of $200,000 from the estate; you'll each have to report $100,000 of accrued interest; and you'll each pay roughly the same amount of income tax on the accrued interest. Moreover, you won't have to pay the high tax rates imposed upon estates and trusts and, in fact, you'll still be able to benefit from the favorable tax brackets available through income-splitting.

This approach may not always be the best solution, but it is an option that should always be considered when property in an estate or trust contains income in respect of a decedent (IRD). In all cases like this, you should work the numbers to see which alternative is best for you and the other beneficiaries, then proceed accordingly.