April 29, 2012 - Phil Hodgen

How the IRS can make RRSP cleanups painless

I get two or three calls a week from Canadians living in the United States who learn — to their horror — that U.S. tax paperwork should have been filed for their RRSPs. At the moment, the only official solution is an expensive one: ask the IRS to issue a private letter ruling to allow you to file late Form 8891s to fix the problem.

There is a short-term and a long-term solution. I’m working on both.

Short-term solution

The short-term solution is that I will do a workshop in July. Ten people maximum. You will do your own private letter ruling. I will give you all of the forms to use. You do the work and save gobs of money. Sign up on the RRSP workshop mailing list to learn more about this.

The workshop won’t solve the problem entirely, but it will make it a lot cheaper for you to get a solution.

Long-term solution

The long-term solution is to get the government to change the rules. The problem with unfiled Form 8891s is a problem created by the tax laws. Tax laws can be changed to eliminate the problem they create.

I am going to Washington DC to meet with people from the IRS. The magic date is May 7, 2012, 10:00 a.m. Along with my co-author, Steven Walker, I will be presenting a position paper suggesting that the IRS change the rules. If this is successful, I will have participated in killing a small cottage industry for tax lawyers. That’s a good thing.

In advance conversations with IRS personnel, I find them to be sympathetic and openminded about making some changes. They have asked for concrete suggestions–what can they do, and what legal authority do they have for taking these actions?

Here are three ways I think the objective can be accomplished.

Option 1 — “Everything’s OK, carry on”

The first and easiest solution would be for the IRS to issue a notice telling the world “Hey, if you didn’t file a Form 8891 for your RRSP in the past, it’s OK. We won’t take any action.”

This has actually happened before. Notice 2003-25, issued by the IRS, was one of a string of pronouncements from the Service about RRSPs. These pronouncements eventually culminated in Form 8891 and an admirably simpler system than had been in operation before that.

In Notice 2003-75, the IRS said:

Treasury and the Internal Revenue Service have become aware that many taxpayers with interests in Canadian registered retirement savings plans (RRSPs), as well as the custodians of such plans, are unfamiliar with the requirements for filing Forms 3520 and 3520-A. Under the circumstances, the IRS has determined that it will enforce neither filing requirements, nor penalties under section 6677, for Forms 3520 and 3520-A with respect to such plans for tax years before 2002, and will grant additional time to file these forms for 2002.

An immensely sane and humane solution. Taxpayers didn’t know they had a problem. The government understood that this was a “no harm, no foul” situation. It was a paperwork issue only. The IRS said “we won’t chase you for penalties, and here is some extra time to take care of things for the tax season you’re in right now.”

It won’t happen again, unfortunately. This perspective does not exist at the IRS any more. Exhibit A: any sentence that has the words “voluntary disclosure” in it.

But it would be a great solution. It is impossible to commit tax evasion with an RRSP. It is as ludicrous as pretending you will use your 401(k) plan to cheat on your taxes. It’s impossible. So there is no risk to the government. And in fact the government has less paperwork to deal with. Every time a piece of paper is filed with the IRS, someone has to deal with it. Why not cut out unnecessary work at the IRS?

This could be coupled with a change in the presumption. Currently the law says that if you are a Canadian and you become resident in the USA, your RRSP is not treated like a pension (thus tax-exempt) in the USA unless you make a specific election under the US/Canadian treaty. It would be just as easy for the presumption to be that RRSPs are automatically treated as pensions in the USA unless you specifically opt out and make them taxable.

I understand that this reversal of presumption was actually discussed in the early 2000’s but the Treasury Department shot the idea down. Pity, that. If the IRS could save itself from processing a few hundred thousand useless pieces of paper, it might save a buck or two in its budget.

TL;DR – The IRS could say “Go and sin no more” to eliminate past problems (they’ve done this before), and give Canadians an automatic treaty election to protect their RRSPs in the USA going forward. Won’t happen.

Option 2 — PLR lite

The next option is not pie in the sky. It is possible.

Here’s the idea. The current rules say that if you didn’t file Form 8891 in prior years, the only way you can fix it is by asking the IRS for permission to do some late filings. The authority that the IRS has for giving you a hall pass to file a late Form 8891 is in Treasury Regulations Sections 301.9100-1 and 301.9100-3. (Insider jargon: this is “9100 relief”).

This is done by applying for a private letter ruling. The current lowest filing fee charged by the IRS is $2,000. You do a bunch of paperwork, tell the IRS why you should get to fix your problems, and if you’re lucky (and you usually are), you will get a ruling in your favor. You then take that piece of paper, make a bunch of copies, and file amended tax returns going back six or eight years (currently the IRS Associate Chief Counsel’s office will allow you to go back eight years.

Even if you don’t hire a law firm like us to do your private letter ruling, you’ll have to hire someone (and spend money) or do it yourself (and invest the time). Plus you have the out of pocket cost of the filing fee. The bare minimum cost is the $2,000 filing fee the IRS charges. Which by the way was $625 until February, 2012. Grrrr.

Remember the key thought here — you are asking for “9100 relief” so you can file late Form 8891s.

Let’s now jump to a completely different area of tax law and see where the IRS has created a “9100 relief lite” system for dealing with late paperwork. I think they can adopt the same logic (and the same solution) for RRSPs and late filing of Form 8891.

Rev. Proc. 2009-41 is where you can find the template for the RRSP solution.

Form 8832 is a form you can file to choose the way a particular business entity will be taxed. Depending on the circumstances, you might treat a limited liability company as a corporation, a partnership, or it might be treated as if it doesn’t exist.

As you might guess, sometimes people start up a business and forget to file this form. They plow forward in life assuming their business is going to be taxed in a certain way, but because they forgot to file Form 8832, their assumption is . . . uhhhhh . . . wrong.

No problem, says the IRS. If you catch your problem within 3 years and 75 days, you can make a retroactive election and all is forgiven. Just jump through the hoops that are described in Rev. Proc. 2009-41.

Three years! Many of my callers would jump at this. It would solve their problems entirely. They could fix their RRSP late Form 8891 problems on their own, without spending money on lawyers.

To fix the Form 8832 problems, you tell the IRS that the U.S. Treasury won’t suffer as a result of the retroactive fix you’re doing, and you give a reasonable cause statement — why you didn’t file Form 8832 on time, and why this was reasonable.

This is relief under Treasury Regulations Section 301.9100-3 (just like relief for late Form 8891 problems with RRSPs) but expedited. If this concept was extended to RRSPs, this means that anyone who caught the problem within three years would be able to file some paper with the IRS (for the cost of the paper, postage, and time) and the problem would be solved.

My suggestion for this mechanically would be that a person would file an amended tax return (Form 1040X) with the late Form 8891 attached, and also attach a statement modeled after the statement required in Rev. Proc. 2009-41.

I can see this as a possibility. I’m cautiously hopeful.

Option 3 — use the treaty election rules

The third option the IRS could use to solve the “late Form 8891” problem is by looking at the problem through the lens of the income tax treaty.

Form 8891 is a form by which a taxpayer makes an election under the US/Canadian income tax treaty to have an RRSP taxed (in the USA) as a pension, just as it is in Canada. Remember this key concept: Form 8891 is a treaty election form.

Section 6114 is the law that says a taxpayer must report a treaty-based position to the IRS. This means if you are claiming the benefits of a treaty to reduce your tax liability, you can only do so if you notify the IRS that you’re doing it.

There are Treasury Regulations issued under Section 6114. They give us a possible escape hatch right now. If not, they give us a clue to what could be done with an amendment to the Treasury Regulations.

Treasury Regulations Section 301.6114-1(c)(2) says:

Reporting [i.e., telling the IRS about your treaty-based claim] is waived for an individual if payments or income items otherwise reportable under this section (other than by reason of paragraph (b)(8) of this section), received by the individual during the course of the taxable year do not exceed $10,000 in the aggregate or, in the case of payments or income items reportable only by reason of paragraph (b)(8) of this section, do not exceed $100,000 in the aggregate.

The reference to paragraph (b)(8) is a reference to making a treaty election to be treated as a resident of another country. We don’t care about that problem. We’re dealing with someone who is a Canadian fully resident in the USA. So what this provision tells us is that the IRS gives out a hall-pass and you don’t have to do any reporting if you are a human and you have income items under $10,000 in a year.

Well. Let’s just say that most RRSPs do not generate $10,000 of income in a particular year. So filing the treaty election isn’t technically required.

The IRS has specific statutory authority under Section 6114(b) to waive treaty reporting requirements:

The Secretary may waive the requirements of subsection(a) with respect to classes of cases for which the Secretary determines that the waiver will not impede the assessment and collection of tax.

RRSPs should be a classic case for exercising that discretion.

In summary

I think there are three different ways that the IRS could solve the problems of late Form 8891 filings and allow people to straighten out their tax paperwork and get their RRSPs fully compliant.

The IRS will not lose any tax revenue by doing this. When distributions are made, the CRA will collect tax by withholding. The U.S. will know about this because the IRS and CRA talk to each other. So every dollar of RRSP distribution will be taxed in the USA.

The IRS will have less work to do. Less paper to file. Fewer private letter rulings to process at Associate Chief Counsel (International). Taxpayers will have less stress and less expense. What’s not to like?