The various states have laws on their books that require an entity holding “unclaimed property” to turn that property over to the state. Generally, this transfer takes place when the account owner fails to take any action with regard to the property and the holder of the property is unable to locate that owner.
Such property can include individual retirement accounts. In Revenue Ruling 2018-77 the IRS rules on circumstances when the payor will or will not be required to withhold taxes from the transfer to the state as well as the reporting requirements on a Form 1099R when such a distribution takes place.
The IRS outlines the facts to be used in this ruling as follows:
Individual C has an interest in IRA O, a traditional IRA trusteed by Trustee Y. Individual C, a U.S. person under § 7701(a)(30)(A) with a calendar year taxable year, has not made a withholding election with respect to her interest in IRA O. State J law requires Trustee Y to pay Individual C’s interest in IRA O to the State J unclaimed property fund under which a claim for property may be made by the owner.1 In 2018, Trustee Y pays Individual C’s interest in IRA O, which has a value of $1,000, to the State J unclaimed property fund.
The first question the IRS addresses is whether the holder of the account is required to withhold federal tax on the payment.
The ruling finds the answer is yes. The ruling turns to IRC §3405 which provides withholding rules for “designated distributions” with distributions from an IRA being one such category of designated distributions. While a designated distribution does not include any portion of a distribution that is reasonable to believe is not subject to tax, IRC §3405(e)(1)(B) provides that any distribution from an IRA (other than a Roth IRA) is treated as a taxable distribution for these purposes.
IRC §3405(b)(1) provides a general rule that a payor is to withhold 10% by default from any nonperiodic distribution from an IRA. An individual can elect, under IRC §3405(b)(1), not to have any withholding apply to the distribution. But since the taxpayer in this case did not make such an election (presumably because the institution has been unable to contact her), the IRS ruled that withholding was required:
The payment of Individual C’s interest in IRA O, a traditional IRA, to the State J unclaimed property fund, as required by State J law, is a payment from an IRA that is treated as includible in gross income (pursuant to the flush language of § 3405(e)(1)(B)) for purposes of § 3405(e)(1)(B)(ii). Thus, the payment is a designated distribution for purposes of § 3405. The payment from IRA O is not an annuity or similar periodic payment under § 3405(e)(2). Thus, it is a nonperiodic distribution as defined in § 3405(e)(3). Because Individual C has not made a withholding election with respect to the payment, a 10 percent withholding rate applies to the payment pursuant to § 3405(b)(1), and Trustee Y must withhold federal income tax of $100 (10% of Individual C’s $1,000 interest in IRA O).
The ruling in this area most likely was issued because some states likely were complaining when custodians attempted to withhold funds from such transfers, arguing that their statutes require turning over the entire balance. But the IRS has now ruled that federal law would override that provision, with the federal government getting 10% of the balance of the account.
Another issue that would cause concern for a custodian is whether a Form 1099R needs to be issued. The funds are no longer being held in an IRA account, but they also did not end up in the hands of the taxpayer. The IRS, citing Reg. §1.408-7(a), held that such information reporting is required for any distribution, even one that is being made to a governmental agency rather than the beneficiary of the account.
The ruling holds:
Section 1.408-7(a) provides that the trustee of an individual retirement account or the issuer of an individual retirement annuity who makes a distribution during any calendar year shall make a report of the distribution for such year. Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., is used to satisfy this reporting obligation.
Pursuant to § 408(i), Trustee Y must report the $1,000 distribution from IRA O ($900 of which is paid to the State J unclaimed property fund and $100 of which is remitted as federal income tax withholding) on a 2018 Form 1099-R identifying Individual C as the recipient.
Given that the IRS had not previously issued guidance in this area, and it’s very likely that custodians (perhaps under pressure from state agencies) had not been withholding funds and, similarly, had not been issuing Forms 1099R, the IRS is granting conditional transition relief to custodians.
The ruling provides:
A person will not be treated as failing to comply with the withholding and reporting requirements described in this revenue ruling with respect to payments made before the earlier of January 1, 2019, or the date it becomes reasonably practicable for the person to comply with those requirements.
Note the use of the “earlier” test in the relief—it would appear to put the burden on the custodian who fails to withhold or file Forms 1099R for payments made before January 1, 2019 to show why compliance was not “practicable” for the period after this ruling was issued on May 29, 2018.