What happens when clients wait a year to cash a retirement plan distribution check?

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Who wouldn’t cash a check?

You’d be surprised. Some distributions from retirement plans go uncashed, and some are cashed a year after the funds were distributed. But when are these funds taxable? Apparently, this is a big enough issue for the IRS to issue a revenue ruling. This ruling (2019-19) was addressed primarily to the plan administrators for company retirement plans who wanted clarification on when uncashed checks should be considered distributions.

Advisors, too, will want to know how these rules work so they can counsel clients who may cash a retirement plan check the year after the check was issued. This can often happen near year-end when required minimum distributions are taken, or when any other plan withdrawals are made.

The IRS ruled that a payment from a 401(a) tax-qualified retirement plan was taxable in the year distributed — even though the recipient failed to cash the check. The ruling does not indicate whether the same holding would apply if the check were actually received in a subsequent year. The IRS also did not say whether the ruling is limited to 401(a) plan distributions or whether it also applies to IRA distributions.

The IRS also ruled that the plan administrator’s obligations for withholding and reporting arose in the year of distribution, and those obligations were not altered by the recipient’s failure to cash the check during that year.

In 2019, a participant in a 401(a) plan (let’s call her Client A) was entitled to receive a $900 distribution from the plan. The plan administrator (in this case, her employer) withheld federal taxes on the distribution and mailed Client A the remaining amount in a check.

The client received the check in 2019. Although she was able to cash the check in 2019, she chose not to do so.

The revenue ruling addressed three issues:

  1. whether the distribution to Client A was taxable income to her in 2019, even though she did not cash the check;
  2. whether the client’s failure to cash the check in 2019 affected the plan administrator’s federal tax withholding obligation; and
  3. whether the failure to cash the check affected the plan administrator’s reporting obligation.

With respect to the taxation issue, the IRS cited §402(a) of the tax code, which provides that, absent a rollover, any amount distributed from a 401(a) tax-qualified plan is “taxable to the distributee, in the taxable year of the distributee in which distributed.” According to the IRS, since the check was distributed in 2019, the distribution was taxable income to her in 2019, despite her failure to cash the check during that year.

Addressing the withholding issue, the IRS ruled that Client A’s employer, as plan administrator, properly withheld federal taxes on the distribution in 2019 — and her failure to cash the check in 2019 did not change the withholding obligation.

IRS form 1099-R 2019-Ed Slott

Finally, turning to the reporting issue, the IRS noted that the Form 1099-R instructions require the employer (or other plan administrator) to file a form “for each person to whom you have made a designated distribution.” Therefore, the client’s employer was required to file a Form 1099-R for 2019 with respect to her distribution. This reporting obligation was not altered by her failure to cash the check in 2019.

It appears that Revenue Rule 2019-19 was intended to address a question that has long been faced by plan administrators: What are their withholding and reporting obligations when they issue a check that goes uncashed? The IRS made clear that those obligations arise in the year of distribution and are not changed by the fact that the check is not cashed.

It is the first part of the ruling — that the distribution is taxable in the year distributed — that raises a number of questions that require further clarification from the IRS.

1. How far does the taxation ruling go?
The facts involved in this ruling made for an easy outcome on the tax issue. Because the check was distributed and received in the same year, she clearly had taxable income for that year — regardless of what she did with the check. (In a footnote, the IRS said: “For purposes of this revenue ruling, whether Individual A keeps the check, sends it back, destroys it or cashes it in a subsequent year is irrelevant.”)

The only support the IRS cited for its ruling on the tax issue is the language of §402(a), which provides that plan distributions are taxable in the year distributed. However, strict application of this “distribution rule” in every situation appears unreasonable. For example, if Client A’s check had been mailed to her on Dec. 31, 2019, but not received by her until Jan. 2, 2020, it would seem unfair for that payment to be considered 2019 taxable income. But the IRS gave no indication the ruling would not apply in such cross-year situations.

2. Why is there no mention of the receipt rule?
Notably missing from the IRS analysis is any mention of the longstanding “actual receipt rule,” or its corollary, the “constructive receipt rule.”

The actual receipt rule was first adopted by the U.S. Supreme Court in the 1934 case of Avery v. Commissioner, 292 U.S. 210 (1934). In that case, Sewell Avery owned stock in a corporation which declared dividends in (among other years) late 1924 and late 1929.

In both years, checks were mailed to him on Dec. 31, but not received until early the next year. The IRS assessed taxable income for 1924 and 1929 (the years of distribution), and Avery appealed to the Supreme Court, arguing the dividends should have been taxed in 1925 and 1930 (the years of receipt). The court agreed with Avery, citing language in the then-current tax code providing that taxable items are included in gross income for the year received.

Under current IRS regulations, amounts payable to a taxpayer are generally taxable in the year received — unless constructively received in an earlier year. The constructive receipt rule has long been applied as a corollary to the actual receipt rule. The regulations provide that an amount is constructively received by a taxpayer in the taxable year “during which it is credited to his account, set apart for him or otherwise made available so that he may draw upon it at any time.” The constructive receipt rule is designed to prevent taxpayers from deferring taxation by intentionally delaying actual receipt of taxable items that are made available to them.

The receipt rule was applied specifically to IRA distributions by the Tax Court in the case of Millard v. Comm., TC Memo 2005-192. In May of 2001, SouthTrust Bank issued Arthur F. Millard a check in the amount of $10,841.06 for an IRA distribution. He did not present the check for deposit until 2003, at which time SouthTrust Bank canceled the original check and presented him with a replacement check. The IRS issued a notice of deficiency for Millard’s failure to include the distribution as taxable income for 2001. He appealed to the Tax Court.

The court agreed with the IRS, concluding that “taxpayers must include all items of gross income in the taxable year of actual or constructive receipt” and that Millard was in actual (and constructive) receipt of the check in 2001.

As Client A’s check was both distributed and received in 2019, application of either the distribution rule or the receipt rule would produce the same outcome — the payment is taxable to her in 2019. But the rules would produce different outcomes in a cross-year situation. The same would be true in the common situation in which a plan administrator sends a check to an ex-employee at an incorrect address, and the check isn’t received until a subsequent year.

3. Does Rev. Ruling 2019-19 apply to IRAs as well as to workplace plans?
The facts of Rev. Rul. 2019-19 specifically involved a distribution from a 401(a) tax-qualified plan, and the taxation ruling is solely based on a tax code section that applies only to 401(a) plans. The IRS gave no indication that the ruling also applies to distributions from IRAs. However, the IRS did not specifically say that the ruling is limited to 401(a) plans.

4. Is the IRS applying one taxation rule for plans and another for IRAs?
At first glance, it would seem illogical for the IRS to apply the distribution rule to 401(a) plan payments and the receipt rule to IRA payments. But there is a possible justification for dissimilar treatment. The tax code section governing taxation of 401(a) distributions specifically provides that such distributions are taxable in the year distributed. Perhaps the IRS was taking the position that the specific language of the ruling overrides the receipt rules codified in its own regulations.

By contrast, there is no similar provision in the tax code indicating the year in which IRA distributions are subject to tax. The lack of such a specific provision arguably lends support for applying the receipt rule to IRA distributions, as the Tax Court did in the Millard case.

5. What is the impact on advisors?
If the IRS really intends to apply the distribution rule to all company plan payouts, advisors will need to alert clients as to when a distribution from a retirement plan will be taxable, including RMDs. This would avoid any cross-year confusion, so the client will know the distribution applies to the prior year, even if cashed or received early the next year.

There will be times when a plan sends a distribution check to an ex-employee and the address on file is not correct. Maybe the ex-employee moved and did not actually receive the check until a year later. That employee will have a tax problem, as, under this ruling, that employee will have been deemed to have received the check and will owe tax for the year of distribution. That will be a continuing issue for these employees.

Clients who leave companies and expect future distributions from that company's 401(k) should immediately update the company with any change of address so they receive timely distributions and avoid tax problems on checks that go uncashed until a later year.

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IRS Retirement planning Retirement income Tax laws IRAs RMDs 401(k) Tax planning Tax code