September 27, 2018
When Individual Retirement Accounts (IRAs) are deemed unclaimed, they generally must be escheated to the state of the owner’s last known address as reflected on the books of the company holding the property. That basic principle has been long established, but there have been different interpretations of the federal income tax treatment of those transactions. Some financial companies have approached the escheatment as a simple transfer of ownership without federal taxable consequences, while others have treated it as a taxable distribution requiring issuance of a Form 1099-R to the owner of the IRA.
Earlier this year, the Internal Revenue Service (IRS) released Revenue Ruling 2018-17, which addresses this discrepancy in treatment in the case of a traditional IRA.
When escheating unclaimed traditional IRAs, fiduciaries are now required to issue a Form 1099-R to the IRA account holder and withhold ten (10) percent federal income tax (unless the IRA account holder has made a valid election not to have withholding apply to a non-periodic distribution). This ruling emphasizes that federal tax withholding applies because the escheatment qualifies as “a distribution or payment from or under an IRA” per Section 3405 of the Internal Revenue Code (IRC), and, therefore, is “includible in gross income”. In addition, the ruling held that such information reporting is required for any distribution under IRC section 408(i), even one that is being made to a governmental agency rather than the beneficiary of the account.
Many issues related to the federal withholding and reporting obligations related to IRAs remain uncertain. First, note that Revenue Ruling 2018-17 is specific to the treatment of a traditional IRA, it does not address Roth IRA escheatment. Further, the ruling doesn’t appear to address situations such as an early distribution for reporting to states that do not require the escheatment of an IRA before the owner reaches a required minimum distribution event, such as turning 70½ years old. In explanation, note that some state unclaimed property laws require that an IRA to be escheated based upon a period of inactivity by the IRA account owner, mailings to the owner that have been returned as undeliverable, and/or the presumed death of the owner.
For IRAs that include illiquid assets, fiduciaries are faced with an additional challenge: to satisfy the ten (10) percent withholding requirement, the fiduciaries would be required to liquidate non-cash assets, yet they are not empowered to do so without their clients’ approvals. It is unclear at this point whether the IRS has the authority to mandate the liquidation of mutual funds or securities without the owner’s consent.
By concluding that the fiduciary must report the designated distribution to the IRS on Form 1099-R, the new ruling seems consistent with the requirements for any other type of distribution from an IRA during the calendar year under Treasury Reg. 1.408-7(a). As the majority of states conform to the IRC on either a static or rolling basis, affected companies will also have to consider the state income tax implications of the new ruling.
In light of the previous uncertainty and lack of guidance in this area, the IRS provided for transitional relief to persons required to withhold and report under the interpretation in the ruling. Compliance with the new rule is expected by the earlier of January 1, 2019, or as soon as is “reasonably practicable,” for the fiduciary to comply. But the rule has led to compliance difficulties for mutual funds, broker dealers, and others that have not historically issued Form 1099-Rs upon escheatment. While most banks already have systems in place to process the correct paperwork and make any required payments to the federal and state governments, many other financial institutions are not yet equipped to handle these requirements.
Complying with this change may require companies to put new tracking and reporting systems in place – a task that will need input from multiple stakeholders within the organization. Third-party tax consultants can assist with establishing the appropriate systems to determine if an IRA has truly satisfied the requirements for compliance with state unclaimed property laws. The extra legwork needed to maintain contact with IRA owners to prevent premature escheatment of the owners’ property may ultimately benefit the account owners by preserving their retirement assets.
This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.
The following information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser