You may have disappeared, but rest assured, the IRS will get theirs. There are circumstances where a taxpayer does not receive cash or any tangible thing of value but the IRS is still allowed to tax (think “phantom income” or income from the cancellation of indebtedness). Such circumstances are almost always noteworthy, but when there is a withholding agent that may become subject to penalties for failure to report and withhold (and pay over to the IRS), the circumstances can become positively Kafka-esque.
These were the circumstances in Revenue Ruling 2018-17, recently issued by the IRS. In the Ruling, an IRA trustee was required to make a distribution, but the person entitled to the distribution not only had not made a withholding election, but apparently had disappeared altogether, gone off the grid, or in any event could not be located by the trustee. What to do? Well, enough time passed that the distribution became “unclaimed property” under state law, and the distribution had to be paid over to the state under its escheat law. (These escheat laws vary state-by-state. Under Pennsylvania law, most amounts are subject to a three year “dormancy period”, after which they are considered unclaimed, but there are different dormancy periods for certain types of payments.)
So the trustee paid the amount over to the state. End of story? Well, no. Revenue Ruling 2018-17 holds that since the distribution was subject to withholding, the trustee should have withheld the appropriate tax, paid it over to the IRS, and reported the withholding, in accordance with the IRA rules; and paid over only the net after-tax amount to the state. In effect the IRS has said “The poor missing taxpayer’s net after-tax amount may be unclaimed, but we’re here to claim Uncle’s share.” And here’s the Kafka-esque part: the trustee could conceivably be liable for the withholding it did not make, and penalties for failing to withhold and report. Since the trustee has already paid over the full amount to the state, these amounts are going to come out of its pocket.
This would no doubt be an unhappy surprise for the trustee caught between the rock of the escheat law and the hard place of the IRS. Such an unhappy surprise that the IRS in Revenue Ruling 2018-17 has granted trustees or other similar payors a modest grace period in the form of “transitional relief.” A trustee or other similar payor will not be treated as having failed to comply with the withholding and reporting requirements 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.” (I quoted this language so that no one could think that any normal person, like me, would ever “communicate” like this.) Given the stakes, I don’t suppose that any prudent trustee would pay over to the state without figuring out the withholding and reporting consequences, and hoping to rely on an argument that compliance was not “reasonably practicable”, unless the penalty for failing to comply with the escheat law was greater than the possible penalties for failing to withhold and report.
Like I said, a rock and a hard spot.
Written by E. Morgan Maxwell
Since beginning his own firm, Mr. Maxwell has continued a tax-law oriented practice encompassing a wide range of transactions, planning and dispute resolution. His dispute resolution experience includes involvement at all levels of the Internal Revenue Service (Examinations, Appeals, Collections, Office of Professional Responsibility, the U.S. Tax Court), the Pennsylvania Department of Revenue, the Tax Litigation Section of the Pennsylvania Attorney General’s Office, Pennsylvania Commonwealth Court, Common Pleas Court and local taxing jurisdictions in southeastern Pennsylvania.
