Individual retirement accounts1 can be one of the most significant portions of an individual’s estate because they accumulate wealth on a tax-deferred basis. Contributions to regular IRAs are made before income is subjected to taxation, and the profits from investments are only subjected to taxation when distributed to the beneficiary. Thus, the longer an individual is able to keep assets in an IRA, the greater the potential for tax-deferred wealth accumulation. As a result, the beneficiary designation on an IRA is an important decision because it determines not only who receives the distributions, but also the period of time over which the IRA can be distributed.2 Naming a nonresident alien (NRA), that is, a foreign individual, as the beneficiary can significantly complicate the distribution process by erecting legal and procedural hurdles that must be overcome before the NRA can receive distributions—hurdles that are absent if the beneficiary is domestic.
Therefore, your clients should avoid naming NRAs as beneficiaries of their IRAs whenever possible.3 Nevertheless, NRAs are sometimes named as beneficiaries if a loved one lives abroad or if a named beneficiary relocates, and the beneficiary designation is never changed. In this circumstance, you should determine as soon as possible whether the NRA should begin the process of obtaining a U.S. individual taxpayer identification number (ITIN). As discussed in more detail below, the NRA may need an ITIN to: (1) reduce or eliminate a 30 percent withholding tax on the distributions; and (2) meet the identification requirements necessary to set up a rollover or inherited IRA, which provides beneficial tax treatment compared to a lump sum payment.
Generally, NRAs are subject to a 30 percent tax on items of income they receive from sources within the United States that aren’t derived from the conduct of a trade or business in the United States.4 This tax is typically collected by way of withholding at the source.5 Thus, the financial institution administering an inherited IRA for an NRA beneficiary is required to withhold 30 percent of each distribution, unless reduced by an income tax treaty.6
Many of the income tax treaties that the United States has entered into follow the U.S. Model Income Tax Treaty (the Model Treaty). Article 17 of the Model Treaty provides that “pensions and other similar remuneration” are taxable to an individual only in his state of residence. The Treasury Technical Explanations state that the phrase “pension distributions and other similar remuneration” includes both periodic and lump sum payments and is intended to encompass distributions by IRAs.7 Thus, under the Model Treaty, only the country where the NRA beneficiary lives would tax the distribution, and no U.S. withholding tax would apply.8
It’s, therefore, important to first determine whether the NRA’s country of residence has an income tax treaty with the United States and, if so, whether that treaty contains a provision similar to the Model Treaty’s elimination of withholding tax on distributions from IRAs. If there’s no treaty or similar provision, the NRA will likely be subject to the 30 percent withholding tax, along with whatever taxes are imposed on distributions from IRAs in the NRA’s country of residence (amounting to a double taxation). If the NRA does qualify under a treaty similar to the Model Treaty, the NRA must obtain an ITIN to invoke the terms of that treaty and avoid the 30 percent withholding tax because the document that the NRA must complete and present to the financial institution making the distribution requires the NRA to provide an ITIN.
Moreover, a financial institution might withhold 30 percent of the distribution even when the NRA qualifies for treaty benefits—either because of a mistake or because the NRA hasn’t obtained an ITIN before the first distributions are made—in which case the NRA would need to file a claim for refund on overpaid taxes to recover the withholding, which also requires an ITIN.
In short, to avoid (or reduce) withholding on future distributions under a U.S. income tax treaty or file a refund claim to recover already withheld funds, the NRA beneficiary must have an ITIN.
An ITIN is not only relevant to invoke benefits under a U.S. income tax treaty, but also may be necessary if an NRA wishes to open a rollover or inherited IRA, instead of taking a lump sum payment of retirement benefits.
In response to the Sept. 11 attacks, on Oct. 26, 2001, President George W. Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act (the Patriot Act).9 Title III of the Patriot Act10 directly affects how financial institutions, including those managing IRAs, do business. The main purpose of Title III is to prevent and detect money laundering, which is a potential source of funding for terrorism. Federal regulations enacted under Section 326 of the Patriot Act require all financial institutions to have a customer identification program (CIP) that verifies the identity of every “customer” who seeks to open an account.11 While there are exceptions for certain employer-established IRAs,12 “where an individual opens an individual retirement account in a bank, the individual who opens the account is the bank’s ‘customer’” and, therefore, subject to the applicable CIP rules.13
The CIP rules establish the minimum identification information a financial institution must collect from a customer before opening a new account. The four data items required for all new customer accounts are:
2. date of birth;
3. residential or business address (a post office box isn’t acceptable because law enforcement agencies should be able to contact an individual at a physical location); and
4. identification number (such as a Social Security number, ITIN or passport number).
Beyond these items, financial institutions are required to develop CIP procedures appropriate for the sizes and types of their business operations. Specifically, the government guidance on these rules states that the:
specific minimum requirements in the rule, such as the four basic types of information to be obtained from each customer, should be supplemented by risk-based verification procedures, where appropriate, to ensure that the bank has a reasonable belief that it knows each customer’s identity.14
Therefore, financial institutions must develop additional CIP requirements that are appropriate to the institutions’ size, market and customer base to ensure they have the information necessary to verify each customer’s identity.15
Thus, a financial institution may determine that it can only accept a U.S. residential or business address or U.S. identification number, if it feels that a foreign address or foreign identification number wouldn’t be sufficient for its identification purposes. The requirements that an NRA will face at any given financial institution vary and depend on the written CIP rules of that particular institution, rather than the broad minimum requirements of the Patriot Act.
If an NRA wants to set up a rollover or inherited IRA, which provides tax benefits, the financial institution will be required to open a new account and will be subject to the Patriot Act and the institution’s own CIP rules. Because any given financial institution’s CIP rules might require an ITIN before attempting to open a rollover or inherited IRA, an NRA should inquire into the relevant financial institution’s CIP rules and obtain an ITIN, if needed.
This becomes less of an issue if the NRA takes a lump sum distribution of the IRA, as most financial institutions won’t be required to follow their CIP rules in such an instance because they’re only distributing funds to the NRA, rather than opening a new account subject to the Patriot Act. However, it’s always possible that a financial institution will, nonetheless, require an ITIN per its own internal guidelines.
Because of all of these variables, if a party plans to designate an NRA as a beneficiary under an IRA, the burdens and flexibility of various CIP rules are relevant factors in determining which financial institution should be used to open the account in the first place.
Obtaining an ITIN
To reduce the withholding tax under an income tax treaty or meet the Patriot Act’s identification requirements, an NRA may have to obtain an ITIN. In addition, to qualify for treaty benefits, the NRA would need to complete, sign and submit an Internal Revenue Service Form W-8BEN (Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding).
Filing Form W-7. With limited exceptions,16 any NRA who files U.S. tax documents with the IRS must indicate his ITIN.17 This rule applies to an NRA who files a beneficial owner withholding certificate, Form W-8BEN, to claim the benefit of a reduced rate of withholding under an income tax treaty, such as on distributions from IRAs.18
Form W-7 is the Application for IRS Individual Taxpayer Identification Number. The instructions for Form W-7 provide that ;certain nonresident aliens must get an ITIN to claim a tax treaty benefit even if they do not have to file a U.S. tax return.; Thus, obtaining an ITIN and using it on the Form W-8BEN doesn’t itself mean that the NRA has to file a U.S. income tax return.
To obtain an ITIN, the individual must furnish the IRS or an “acceptance agent” (as described below) with the information required by Form W-7 and its accompanying instructions, including the individual’s name, address, foreign tax identification number (if any) and specific reason for obtaining an ITIN.19 The individual must make this application far enough in advance of the ITIN’s first required use so as to permit the IRS to issue the number in time for its use.20 It may take six to eight weeks for the IRS to issue the ITIN. Thus, to ensure the ITIN’s timely receipt, NRAs should submit their Forms W-7 a minimum of eight weeks before the dates they must submit Form W-8BEN to the relevant financial institution.21
As indicated above, instead of filing the form with the IRS, an NRA may submit the Form W-7 to an “acceptance agent,” which would then transmit the completed Form to the IRS.22 (See www.irs.gov/individuals/article/0,,id=96304,00.html for a current list of IRS authorized acceptance agents.)
An ITIN is assigned to an individual on the basis of information reported on Form W-7 and any accompanying documentation the IRS requires.23 An applicant for an ITIN must submit documentary evidence prescribed by the IRS to establish alien status and identity. Examples of acceptable documentary evidence for this purpose may include an original (or a certified copy of the original) passport, driver’s license, birth certificate, identity card or immigration documentation.24
As of January 1, 2013, copies of the above documents must be certified by the issuing agency or by an officer at a US Embassy or Consulate. Copies notarized by a foreign notary are no longer acceptable. Original documents submitted will be returned to the mailing address shown on the Form W-7.25 If at all possible, original documents should never be sent due to the risk that they’ll be lost.
Filing Form W-8BEN. Once an NRA has an ITIN, to secure treaty benefits, an NRA will also need to complete, sign and submit a Form W-8BEN to the financial institution certifying its entitlement to U.S. treaty benefits.26
A foreign person that’s the beneficial owner of an amount otherwise subject to withholding must furnish the withholding agent with a completed Form W-8BEN.27 The withholding agent is any person, U.S. or foreign, who has the control, receipt, custody, disposal or payment of an item of income of a foreign person subject to withholding.28 Thus, for the 30 percent withholding tax not to apply (or be reduced), an NRA should provide the completed Form W-8BEN to the financial institution in advance of any distributions from the IRA.29
A Form W-8BEN is valid only if: (1) its validity period hasn’t expired; (2) it’s signed under penalties of perjury by the beneficial owner; and (3) it contains all of the information required on the form.30 The required information is the beneficial owner’s name, permanent residence address and ITIN.31 In the case of a Form W-8BEN furnished to claim a reduced rate of withholding under an income tax treaty, the residence must be determined in the manner prescribed under the applicable treaty.32 The address of a financial institution with which the beneficial owner maintains an account, a P.O. box or an address used solely for mailing purposes aren’t residence addresses for this purpose.33
1. For purposes of this article, the term “individual retirement accounts”(IRAs) collectively refers to IRAs, Roth IRAs, qualified retirement plans and all similar retirement plans. Unless otherwise noted, all Code, Section, IRC Section and Treasury Regulations Section references are to the U.S. Internal Revenue Code of 1986, as amended or the regulations issued pursuant thereto.
2. The federal rules for the period of time over which retirement assets can be distributed are covered by the complex rules of IRC Sections 401, 402, 408, 408A, 457 and the regulations thereunder. These rules are beyond the scope of this article.
3. If the designated beneficiary of the IRA is a U.S.-situs trust set up for the benefit of a nonresident alien (NRA), then some of the issues discussed below may be eliminated, but additional concerns may arise. For instance, the trust’s taxpayer identification number and the trustee’s U.S. residential or work address may be used to comply with customer identification requirements that the NRA can’t meet. However, the period of time over which the IRA can be distributed may be reduced to the life expectancy of the oldest trust beneficiary if it’s a see-through trust with multiple beneficiaries or subject to the 5-year rule if it’s a non-see-through trust. See Treas. Regs. Sec-
tions 1.401(a)(9)-3, -4 and -5. Even if the trustee can set up separate accounts so the distribution period for each trust beneficiary is based on each beneficiary’s own life expectancy, the trustee would be required to act as the withholding agent for any withholding taxes owed on the distributable net income payable to an NRA beneficiary (unless reduced by a U.S. income tax treaty, as discussed below). See Treas. Regs. Sections 1.1441-5(b)(2)(ii) and (iii).
4. IRC Section 871(a)(1).
5. IRC Section 1441(a).
6. IRC Section 894(a); Treas. Regs. Section 1.1441-6; Private Letter Ruling 9806012 (Feb. 6, 1998).
7. Article 18, Technical Explanation of the 1996 U.S. Model Income Tax Convention.
8. Treaties with every country are negotiated separately and should be consulted for any differences from the U.S. Model Income Tax Treaty and any specific limitations on treaty benefits.
9. Pub. L. 107-56.
10. The International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001.
11. 31 C.F. R. 103.121(b).
12. The customer identification program (CIP) rules exclude accounts opened for the purpose of participating in an employee benefit plan established under the Employee Retirement Income Security Act of 1974 (ERISA) from the definition of “accounts.” In addition, if an employer established a trust, custodial or other administrative account at a bank to maintain a non-ERISA employee retirement account, the employer, rather than the individual, is considered the bank’s customer. Guidance Issued on Customer Identification Regulations, FAQs: Final CIP Rule, issued by the Federal Reserve Board, FDIC, the Financial Crimes Enforcement Network, National Credit Union Administration, Office of the Comptroller of the Currency, Office of Thrift Supervision and the US Treasury (issued in January 2004 and revised in April 2005) (the FinCen FAQs) at FAQ #7.
14. FinCen FAQs Introduction.
16. There are certain situations in which an individual taxpayer identification number (ITIN) isn’t required, for example, when an NRA receives dividends from publicly traded companies.
17. IRC Section 6109(a)(1).
18. Treas. Regs. Section 1.1441-6(c)(1) & (2).
19. Treas. Regs. Section 301.6109-1(d)(3)(ii).
21. Thus, if an NRA waits too long to obtain an ITIN, the delay could potentially cause a failure to timely receive a required minimum distribution (RMD) and trigger a 50 percent IRC Section 4974 penalty (waivable for reasonable cause). However, it’s sometimes not possible to get this payment timely made, particularly when the participant dies very late in the year without having taken the RMD or when a trust is the named beneficiary and arrangements are being made to pay the individual trust beneficiaries directly. In case of an IRS audit under these circumstances, the financial institution often can provide documentation to the IRS indicating that the process of identifying and contacting the named beneficiaries was ongoing before the required distribution date. The IRS tax penalties are specifically intended for those individuals attempting to avoid taking their RMD payments, so the penalties should be waivable in such situations.
22. Treas. Regs. Section 301.6109-1(d)(3)(iv).
23. Treas. Regs. Section 301.6109-1(d)(3)(iii).
25. Instructions to Form W-7 (January 2011).
26. Treas. Regs. Section 1.1441-1(e)(2)(i).
27. Instructions to Form W-8BEN (Feb. 2, 2006).
28. Treas. Regs. Section 1.1441-7(a)(1).
29. See supra note 27.
30. Treas. Regs. Section 1.1441-1(e)(2)(ii).
31. Ibid. See supra note 27.
32. Ibid. See also Treas. Regs. Section 1.1441-6(b).
33. See supra note 30. A taxpayer who takes a “treaty-based return position” must, enerally, disclose this position on an IRS Form 8833 (a pro forma tax return). The regulations generally exempt from disclosure a treaty position with respect to an amount that, but for the application of the treaty, would be subject to withholding, unless the treaty provision imposes any other conditions. Given the differences in the terms of various U.S. income tax treaties, it’s unclear whether any particular NRA would be required to disclose a treaty-based return position. Accordingly, any NRA should directly discuss with his advisor the potential Form 8833 filing obligations.