IRS Creates Legal,Ops Headaches for Escheated IRAs

(Editor’s Update on November 29, 2018): Tax operations, compliance and technology managers at US financial firms now have until January 1, 2020 to implement the Internal Revenue Service’s rule to withhold taxes on unclaimed individual retirement accounts. The IRS’ one-year extension is far less than the 18 months requested by the securities industry but provides additional time for them to make the required contractual, operational and reporting changes. 

Published on October 4, 2018 : Tax operations, compliance and technology managers at mutual funds, banks and broker-dealers are starting to lose plenty of sleep over the impracticalities of meeting a new ruling from the US Internal Revenue Service that they deduct withholding tax from unclaimed retirement accounts before they are transferred to state coffers.

In late May, the IRS said that funds which leave an IRS-qualified IRA custodian are considered a “distribution” and are therefore subject to withholding tax of at least ten percent. The states can’t withhold the tax because are not IRS-qualified custodians of IRAs. That leaves financial institutions and corporations to fulfill the onerous task, which the IRS wants them to do beginning January 2019.

The IRS has not publicly disclosed just how much revenue it hopes to earn from the new withholding tax rule. Only a small percentage of IRAs ever become escheatable, Wall Street operations professionals tell FinOps Report and trade groups representing broker-dealers, banks, transfer agents, insurance firms and legal professionals specializing in unclaimed property insist that they can’t possibly comply with the IRS’ ruling for legal and operational reasons. They have teamed up under the umbrella of the Holders Coalition to lobby the IRS to amend its new rule or at least delay its implementation.

Legal Obstacles

For starters, say members of the Holders Coalition, financial firms don’t have the right to liquidate any shares in investor accounts which would be necessary to deduct the withholding tax. “The only exception would be if owners of the IRAs were to have agreed to the liquidation of their shares in their custodial agreements at the time of account opening,” explains Jennifer Borden, president of Boston-based unclaimed property consultancy Borden Consulting who represents the Securities Transfer Association, the trade group for registered shareholder recordkeepers.

In a September 4 letter to the IRS and its parent, the US Treasury, the Holders Coalition specifies two separate rules imposed by the broker-dealer overseer Financial Industry Regulatory Authority and the Securities and Exchange Commission as restricting the ability of financial firms to liquidate shares in customer accounts. FINRA’s Rule 408(a), meant to protect a customer’s interest in an account, defines prohibited conduct to include purchasing or selling securities in a customer’s account without first receiving its explicit authorization. “Holders subject to FINRA’s rule are concerned about the regulatory and civil liability they are likely to incur as a result of liquidating a customer’s account without lawful authority to do so,” writes Toni Nuernberg, in her role as administrator of the Holders Coalition. Nuernberg, who is also executive director of the Unclaimed Property Professionals Organization (UPPO) in Golden Valley, Minnesota also points to the SEC’s Rule 17Ad-12 as prohibiting a transfer agent from liquidating the shares of clients’ shareholders.

Retail investors typically open IRA accounts with either banks, broker-dealers, mutual funds or even corporations using either cash or securities or a combination of the two. As a rule of thumb, IRAs must be escheated or transferred to a state of the last known residence of the investor if there is “no activity” in the account within about three years after the investor reaches the age of 70 1/2. No activity refers to not making any deposits or withrawals in or out of an IRA, not communicating in any way with the financial institution holding the account or having a mailed statement returned to the bank or other financial firm marked as “undeliverable.”

Until now, financial institutions and others have not been computing and withholding tax from escheated IRA accounts believing that transferring accounts to states is an in-kind transfer. The IRS has reportedly told financial firms that all they have to do is review their custodial agreements with customers to determine if the withholding tax is permitted for escheated IRAs. The IRS’ presumption: the agreements already do or can easily be changed.

Not so, counter unclaimed property experts. “Custodial agreements signed at the time of account opening have not been used in this capacity and will have to be reviewed to determine if a withholding tax can be applied on escheated IRAs,” explains Christa DeOliveira, chief compliance officer for Linking Assets, a New York-based firm specializing in reuniting investors with their escheated assets.

Then what? “Financial firms would have to contact existing customers to change their custodial agreements and should they reach those customers their IRAs would no longer be considered abandoned,” explains Borden. “Of course, the entire task would be a hefty repapering challenge and would likely only result in changing the time for when an account becomes escheatable.”

Operational Woes

Legal complications aside, financial institutions would have plenty of operational challenges to fulfill the new IRS requirement. “Financial firms would need to first calculate the withholding tax, then determine which securities they would have to sell to come up with the withholding tax, then remit the withholding tax to the IRS, then report and remit the remainder in the account as unclaimed property to the correct state,” says DeOliveira. “The multi-step process would require a major revamping of middle and back-office systems which could easily take a year to eighteen months to complete.”

Operational changes would require substantial technological enhancements and the likelihood of receiving the necessary funding at the eleventh hour to comply with the IRS’ rule is next to nil. Calculating the withholding tax isn’t difficult, but knowing which date it should be calculated on would be. So is knowing which lot of securities to select first or which ones to sell at all. “What if the financial firm were to sell a lot of securities that ultimately causes the investor to lose out on appreciable gains in the value of its securities account,” bemoans DeOliveira. Such an occurrence, she believes, would conflict with the fundamental premise of the SEC’s rules that financial firms must protect investor assets and could open the door for financial firms to be hit with a barage of investor lawsuits.

In a recent joint letter to FinOps Report, the Holders Coalition, the broker-dealer trade group Securities Industry and Financial Markets Association, UPPO, and mutual fund trade group Investment Company Institute, acknowledge their members have their work cut out for them in meeting the IRS’ new rule. “We are still digesting how we would address that [the IRS rule] operationally,” says the letter signed by Nuernberg. “This is of particular concern if the IRA account contains securities as there may be limitations on a custodian’s ability to liquidate securities in order to have the cash to send the tax to the IRS.”

A Better Way

Members of the Holders Coalition, who separately spoke with FinOps Report assert that the IRS could make states rather than financial firms responsible for handling the withholding tax for escheated IRAs. “The states could apply to the IRS to become accredited custodians of IRAs which would allow financial institutions to continue their current process of completing a transfer-in-kind to the states,” suggests Dana Terry, director of the unclaimed property consulting group for Georgeson in Jersey City, New Jersey. “States would then be responsible for the IRS withholding tax upon liquidation of the shares.” Alternatively, the IRS could amend its ruling.

So far, it doesn’t appear that state treasurers responsible for handling unclaimed accounts are willing to tackle the applications necessary to become IRS-accepted IRA custodians. The IRS also isn’t willing to rescind or modify its new ruling.

What if a financial institution were to decide to simply not escheat an IRA account to a state? Legal counsels at financial firms could easily interpret the IRS’ requirement on withholding to apply only to escheatable accounts and not unclaimed IRAs retained by financial firms.

Such an option also has its shortcomings, according to Terry, whose firm specializes in helping corporations meet their unclaimed property escheatment obligations. The reason: states have become more aggressive in their audits of financial firms and other institutions and could fine them should they determine that they have neglected to escheat any accounts pursuant to state unclaimed property laws. Those fines could end up being in the multimillions of dollars, cautions Terry whose firm is owned by Computershare, the US’ largest stock transfer agent.

Fat Chance

What’s left? Apparently, all the IRS is willing to concede for now is to postpone the time for when its new ruling becomes effective. However, even that delay will be far short of the minimum of eighteen months broker-dealers and others are asking for, unclaimed property specialists tell FinOps Report after attending a recent closed door meeting held by the IRS on September 21.

“The IRS has put financial firms and corporations in the position of being between a rock and a hard place in reconciling the incompatible mrequirements of multiple regulators,” says DeOliveira. “The IRS will require us to calculate and remit the withholding tax, but SEC and FINRA’s rules don’t allow us to liquidate shares. Meanwhile, states assert that holders must report and remit traditional IRAs as unclaimed property.”

The only potential salvation for financial firms could come from FINRA and the SEC. Presumably the regulatory agencies could tell the IRS its new ruling conflicts with their own rules and persuade the IRS to change its mind. Alternatively, FINRA and the SEC could direct the IRS that unclaimed IRAs could be escheated, but no assets could be liquidated.

Just how likely is it for either of those options to happen? The SEC declined to comment for this article beyond referring FinOps to the Holders Coalition’s letter to the IRS and US Treasury. FINRA even dismisses the Coalition’s concerns. “We do not view our rules as limiting compliance by members with federal requirements regarding income tax withholding,” insists Robert Colby, FINRA’s chief legal officer in a statement to FinOps Report. When further pressed to explain why so many influential organizations would have a conflicting viewpoint, he would not elaborate further.