In Notice 2018-90, the Internal Revenue Service extends the transition relief period for the new escheated IRA federal income tax withholding and reporting rules by one year. Specifically, the extended transition relief applies to payments made before the earlier of January 1, 2020, or the date it becomes reasonably practicable to comply with the new rules. The extension provides welcome relief to IRA custodians, trustees, and issuers who were facing challenges in implementing the new rules by January 1, 2019.
The new rules provided by the Internal Revenue Service (IRS) in Revenue Ruling 2018-17 earlier this year are an attempt to settle some of the longstanding uncertainty surrounding the federal income tax withholding and reporting requirements for abandoned IRAs escheated to a state unclaimed property fund. In the Revenue Ruling, the IRS holds that a Traditional IRA trustee is required to withhold federal income tax from an escheated IRA at the 10% default rate (since the IRA owner had not made any tax withholding election) and to report the escheatment on IRS Form 1099-R as if it were a distribution to the IRA owner.
Prior to Revenue Ruling 2018-17, the IRS had not issued specific guidance on the tax withholding and reporting requirements for escheated IRAs. Sections 3405 and 408(i) of the Internal Revenue Code (Tax Code) generally require federal income tax withholding and reporting on all IRA distributions, unless an exception applies. There is no statutory exception for IRAs escheated to a state unclaimed property fund.
Although the Revenue Ruling is consistent with a strict reading of Sections 3405 and 408(i) of the Tax Code, it appears to be somewhat at odds with longstanding principles of actual and constructive receipt as applied to escheated property in private letter rulings issued by the IRS on the escheatment of other types of property and in a US Tax Court case dealing with escheated IRAs.
In Private Letter Rulings 200307080 and 200124001, the IRS held that tax reporting was not required for property escheated to a state unclaimed property fund because the taxpayer had no actual or constructive receipt of the property. In Mudd v. Commissioner, T.C. Summary Opinion 2004-1, the Tax Court held that escheatment of an IRA to a state unclaimed property fund was not a taxable event because the IRA owner was not in actual or constructive receipt of the IRA proceeds.
The Revenue Ruling is silent as to whether the IRA owner may roll the escheated IRA over to an eligible IRA and, if the rollover is permitted, when the 60-day period to make the rollover begins. Until the IRS issues further guidance, this remains an area of uncertainty, and accepting rollovers of escheated IRAs may carry some risk of tax reporting penalties for the custodian, trustee, or issuer and adverse tax consequences and tax penalties for the IRA owner, if rollovers are ultimately not permitted or if the rollover is not made in accordance with the guidance.
Although states tend to defer IRA escheatment until the IRA owner is age 70½, some states require escheatment before age 70½. The Revenue Ruling is also silent as to whether an IRA owner who is under age 59½ at the time of an escheatment (in those states that escheat before the IRA owner reaches age 70½) would be liable for the 10% penalty tax for early IRA distributions.
Revenue Ruling 2018-17 is also specifically limited by its terms to a Traditional IRA and does not address the tax withholding and reporting requirements for a SEP, SIMPLE, or Roth IRA.
IRA custodians, trustees, and issuers should make sure that they have reviewed their tax withholding and reporting procedures for escheatment and make the changes necessary to reflect the Revenue Ruling’s holdings for any escheatment that occurs in 2020 and later. The procedures should include a process to liquidate investments in cases where the escheated IRA is provided to the state in kind and there are not sufficient cash assets to satisfy the tax withholding. They should also make sure their operational and administrative systems have been updated to add escheatment as a trigger for tax withholding and completion of a Form 1099-R.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Craig A. Bitman