Cancelled and reissued qualified plan distribution checks, particularly to decedents, should be monitored for payment in light of the Internal Revenue Service’s repeated refusal to repay withholding to payor plans. If a Form 1099-R is filed reporting a distribution that was never received, employers could end up effectively paying twice the withholding amounts.
The cancellation and reissuance of checks often present withholding and reporting dilemmas for payors, particularly when a check is sent at the end of one tax year and replaced with another check at the beginning of the next year, including when the payee is deceased. It is important to be aware that (as a result of a 1981 amendment to Internal Revenue Code (Code) Section 402(a)) constructive receipt principles generally do not apply to amounts held in qualified retirement plans.
Instead, per the Code, qualified plan payments are taxable only when they are “actually distributed.” This requires a careful analysis of the facts and circumstances of the cancellation and reissuance, as well as monitoring of year-end qualified plan payments to ensure that Forms 1099-R are not issued for never-received checks, since the Internal Revenue Service (IRS) will not refund the withholdings once Form 1099-R is issued.
Plan administrators are required to “make returns and reports” to the IRS and to participants and beneficiaries with respect to plan distributions of $10 or more during any year. IRS Form 1099-R is used to satisfy these obligations; it must be filed and, where necessary, corrected by January 31 of the year following the year of distribution. Code Section 3405 generally governs a plan administrator’s withholding responsibilities for distributions from qualified plans. Important to the issues discussed here, “designated distributions” are treated as if they were “wages” paid by an employer to an employee with respect to which there has been withholding under Section 3402. Other than for certain eligible rollover distributions, withholding on distributions from qualified plans is elective.[1] The plan administrator is liable for payment of the tax required to be withheld (unless the plan administrator directs the payor to withhold such tax and provides the necessary information).
Although Code Section 451 sets forth a general rule indicating that an amount is included in gross income in the tax year when it is actually or constructively received, Code Section 402(a) shows that the concept of constructive receipt does not apply to qualified plan distributions.
Instead, that section states that, generally, “any amount actually distributed to any distributee by any employees' trust described in section 401(a) which is exempt from tax under section 501(a) shall be taxable to the distributee, in the taxable year of the distributee in which distributed, under section 72 (relating to annuities).” The pre-1982 language referred to benefits that were “made available”; by changing the language, Congress intended to eliminate the concept of “constructive receipt” as it applied to qualified plans.
Revenue Ruling 2019-19, 2019-36 IRB 64 addresses the impact on an employer’s withholding and reporting obligations as plan administrator when a recipient failed to cash a distribution check from a qualified plan received in December 2019. The employer had withheld tax and mailed the remainder to the recipient. In light of the terms of Section 402(a), the employer’s liability for tax withholding under Section 3405 and reporting obligations under Section 6047 are unchanged. The ruling also specifically states in a footnote that “whether Individual A keeps the check, sends it back, destroys it, or cashes it in a subsequent year is irrelevant.” This language sheds light on the meaning of “actually distributed,” indicating that the act of mailing the check, i.e., effectuating the order to disburse funds from the plan to the recipient, is dispositive. If the benefit is “actually distributed,” then reading Code Section 402 alongside the ruling shows that withholding and reporting on a Form 1099-R for 2019 are required.
The ruling does not directly address a variety of other possible scenarios, such as where the payor cancels the check on account of an erroneous or duplicate distribution or where the check was never received because either the check was lost in the mail or, as discussed below, the payee died. But the ruling implies that these scenarios all raise doubts as to whether distributions actually left the plan and therefore were payments that could be treated as “wages” to the recipients subject to withholding. Thus the facts should be investigated further before concluding that a check was not “actually distributed,” such that current year withholding and reporting are not required.
Checks issued to decedents raise special questions concerning withholding and reporting obligations. Payments made after death are not considered wages for purposes of federal income tax withholding.[2] It follows that neither income nor withholding can be reported on any information return as to the decedent. Nevertheless, a plan administrator may have collected withholding, believing that the payee was still alive. Upon determining that the amount was never paid, the administrator may reverse the payment.
Code Section 3405(e)(1)(B) provides that “the term designated distribution shall not include . . . (ii) the portion of any distribution or payment which it is reasonable to believe is not includible in gross income.” Since the payee’s income was zero, it is arguably reasonable to believe that the unpaid amount cannot be treated as a “designated distribution.” As a corollary, any amounts retained cannot be characterized as withholdings. A plan administrator may thus return the withheld funds to the plan and need not report the failed distribution.
Additionally, Code Section 6414 authorizes a payment directly to an employer (or withholding agent) in any case where federal income tax was overpaid that had not been “deducted and withheld from an employee’s wages.” Where income tax withholding is overwithheld on account of “administrative error,” and ascertained after the return was filed, Treasury Regulations Section 31.6413(a)-2(c) allows the employer that made the error to claim a credit toward payment of employment tax liabilities for the return period in which the adjusted return is filed. If an adjustment cannot be made, the employer can file a claim for refund or credit.
Unfortunately, despite these above-cited Code provisions permitting refunds to employers of income tax withholdings collected in prior years, the IRS has repeatedly rejected refund claims filed by trustees of qualified retirement plans for withholdings collected from checks that were received after the payee’s death, despite the proof provided that replacement checks were sent (without withholding) in the next calendar year, payable to the estate or beneficiaries of the decedent.
First, the IRS contends that these amounts were “distributed” (even though the recipient, being dead, could not cash the check). Second, the IRS contends that since a Form 1099-R reflecting the original payment and withholdings had been filed in the decedent’s name (which frequently happens, when the payor did not learn of the payee’s death until after filing the Form 1099-R), the estate (or beneficiaries) could have filed income tax returns claiming credit for the withholdings. Neither position is supportable.
First, the payor can prove that the first check was never cashed (and could not have been cashed). Second, the payees could not have “claimed credit” for the withholdings reported on the Form 1099-R filed in the decedent’s name without also paying tax on the distribution itself—which would not have happened, since the payees had not even received the funds until the year after the decedent’s death. But the IRS insists its contention is correct, while also refusing to provide any information supporting that such “credit claims” for the overwithholding were ever made.
Thus, the IRS refuses to repay the employer for the withholdings that the IRS received with respect to the initial distributions, except in cases where it is proved that no Form 1099-R was ever sent reflecting that original distribution.
In light of the IRS’s repeated refusal to repay withholdings to the payor plan, plans should take care to monitor all distributions (particularly in December of any calendar year). If a Form 1099-R is filed for that year reporting a distribution that in fact was never received, the employer may effectively be required to pay twice the amounts of those withholdings: one payment that the IRS will likely not refund (i.e., the withholdings on the payment made after the decedent’s death), and another payment to the decedent’s estate (when the check, without withholdings, is paid in the subsequent calendar year).
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:
New York
Mary B. Hevener
Anna M. Pomykala
Washington, DC
Steven P. Johnson
Jonathan Zimmerman
[1] Where elected, the applicable rules (20% withholding on eligible rollover distributions that are not direct rollovers, 10% withholding on other nonperiodic distributions, and withholding as if the distribution were wages on periodic payments) generally apply.
[2] See Rev. Rul. 86-109, 1986-2 C.B. 196; Code § 691(a)(1) (confirming that the decedent does not have “income” after death).