The basic required minimum distribution (RMD) rules are well known by tax advisers and by many clients. Individual retirement account (IRA) owners must take RMDs once they reach their required distribution date or face a penalty of 50% of the undistributed amount.
That said, some of these same IRA owners fail to take RMDs or any distributions. This might go on for many years, leaving a potentially huge tax obligation for the IRA owner, a beneficiary, a trustee or an executor.
What should you as their CPA keep in mind when faced with RMD noncompliance?
Mending a mistake
Let’s first run through several scenarios. For all these situations, IRS Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, can be used to request a waiver of the 50% penalty for an insufficient RMD.
This penalty can be waived if the taxpayer establishes, to the satisfaction of the IRS, that the shortfall in the amount of distributions was due to reasonable error and that reasonable steps are being taken to remedy the insufficient RMDs.
Reasonable steps include taking the RMDs from prior years and accepting the resulting tax obligation. In some cases, however, the individual with the personal liability for the unpaid taxes — such as an IRA owner’s executor — may lack access to the IRA money. This can result in a conundrum that’s not easily resolved.
When the client is alive
Let’s look at the first scenario. John is in his early eighties and has a six-figure IRA. He has never taken any distributions from that IRA, accumulating a huge income tax obligation plus possible penalties.
Assume that John has hired a new CPA who reviews John’s prior tax returns and discovers the lack of RMDs. A CPA who discovers insufficient RMDs with respect to a client must inform the client and urge him or her to fix the issue. Professional responsibilities, including Circular 230, SSTS No. 3, Certain Procedural Aspects of Preparing Returns, and SSTS No. 6, Knowledge of Error: Return Preparation and Administrative Proceeding, are important to consider.
In the real world, though, our hypothetical John may not want to take all the backlogged RMDs and pay the tax. John could be tempted to ignore his CPA’s advice, believing that the shortfall won’t be discovered.
If he chooses to ignore his CPA’s guidance, John should be advised that there is no statute of limitations on RMD shortfalls, unless Form 5329 is filed for the relevant year (Paschall v. Commissioner, July 5, 2011). John must rectify the insufficient RMD to avoid the 50% penalty.
If John still refuses to comply, his CPA should likely disengage from this client relationship. SSTS No. 6 states that, “If a member is requested to prepare the current year’s return and the taxpayer has not taken appropriate action to correct an error in a prior year’s return, the member should consider whether to withdraw from preparing the return…If the member does prepare such current year’s return, the member should take reasonable steps to ensure that the error is not repeated.”
IRA has been left outright
In another example, Mary died and left her IRA to her son, Josh. Here, a CPA who notices any prior RMD shortfalls that occurred while Mary was alive (this applies to the calendar years before her year of death), would be obligated to inform her executor. The executor, in turn, would be personally liable for any penalties that result from noncompliance.
However, if Josh refuses to take the delinquent RMDs, the executor’s liability would remain. This could place the executor’s personal assets at risk, and the executor would lack access to the IRA money. Form 5329 requires reasonable steps to support a request to waive the 50% penalty, but the executor can’t take the reasonable step of rectifying past RMD shortfalls.
If no Form 5329 has been filed, there will be no statute of limitations to eventually protect the executor or the IRA beneficiary or, if different, the estate’s heirs. To collect the tax due, the IRS might pursue the person or people who can be reached easily and with the amplest assets.
Moreover, the executor can’t force a reluctant IRA beneficiary to pay the taxes that are due. This is a potential problem without an easy solution.
IRA has been left to a trust
Many IRA owners name a trust as a beneficiary for asset protection and estate planning. RMD rules apply during the IRA owner’s lifetime and after the IRA passes to the trust.
One good outcome is to have the trust be considered a qualifying trust. Then RMDs may be based on the life expectancy of the oldest trust beneficiary as determined by IRS rules. If the oldest beneficiary is, for example, age 58 with a 27-year life expectancy on the IRS life expectancy table, RMDs may be stretched over 27 years providing a big tax deferral.
With that background, consider this relatively common situation: The IRA owner has died, the IRA was left to a trust, and the trustee has been taking RMDs based on an improper payout period. Years later, it’s discovered that the trust was non-qualifying and the subsequent RMDs from the IRA to the trust haven’t been calculated correctly.
To further illustrate this, suppose that Sarah died in August 2012 before her required beginning date, leaving her IRA to a trust. The required documents were not filed with the IRA custodian by Oct. 31, 2013, so the trust is non-qualifying.
On Dec. 31, 2017, five years after Sarah’s death, the IRA still contained $300,000. Under the five-year rule (which applies to a non-qualifying trust), if Sarah (the IRA owner) died before the required beginning date, the amount in the IRA as of Dec. 31, 2017 should have been zero.
Therefore, tax rules require the entire IRA amount to be distributed, subject to income tax. In addition, a $150,000 penalty (50% of the $300,000 IRA balance) may be imposed if the distribution is not taken timely.
In this scenario, the $150,000 penalty would be the trustee’s responsibility. A CPA who discovers this obligation is required to inform the trustee immediately.
Once informed, the trustee should immediately distribute the IRA balance. The amount to be distributed probably would be taxable to the trust or the trust beneficiary or some combination of the two.
As explained, the trustee should file Form 5329 for 2017, the year the IRA should have been emptied. On this form, the trustee can ask for the penalty ($150,000 in this example) to be waived. The IRS can waive the penalty for good cause.
As a result, the IRS can assert the 50% penalty at any time if a timely Form 5329 isn’t filed. The trustee’s period of personal liability could be significant if the evidence shows that the trustee knew about the insufficient RMD. A trust beneficiary who received IRA money also might be liable for the penalty if the trustee doesn’t pay it.
With all this in mind, here are some key points to consider when dealing with IRA RMDs with your clients.
Inform all clients who owe RMDs about their annual obligation. Keep records of your correspondence, including those notifications.
If you learn of past RMD shortfalls, urge your clients to withdraw amounts in question and consider filing Form 5329 to request a waiver of the 50% penalty.
If you discover that clients are not remedying insufficient RMDs from past years, despite several communications from you, consider whether it is in your best interest to maintain the relationship.
In addition to these, refer to the AICPA’s Tax Ethics and Professional Standards guidance and tools to help you navigate these situations.