Withholding on Certain Distributions Under Section 3405(a) and (b)

SUPPLEMENTARY INFORMATION:

Authority

Section 7805(a) authorizes the Secretary to prescribe all needful rules and regulations for the enforcement of the Code.

Background

Section 3405(a)(1) of the Internal Revenue Code of 1986 (Code) requires the payor of any periodic payment to withhold income tax from the payment. Under section 3405(a)(2), an individual generally may elect not to have section 3405(a)(1) apply with respect to periodic payments made to the individual. Section 3405(b)(1) requires the payor of any nonperiodic distribution to withhold income tax from the distribution. Under section 3405(b)(2), an individual generally may elect not to have section 3405(b)(1) apply with respect to any nonperiodic distribution.

Section 3405(e)(2) defines a periodic payment as a designated distribution that is an annuity or similar periodic payment. Section 3405(e)(3) defines a nonperiodic distribution as any designated distribution that is not a periodic payment. A designated distribution is defined in section 3405(e)(1) as generally any distribution or payment from or under an employer deferred compensation plan, an individual retirement plan (as defined in section 7701(a)(37) of the Code), or a commercial annuity. For this purpose, an employer deferred compensation plan is defined in section 3405(e)(5) as any pension, annuity, profit sharing, or stock bonus plan or other plan deferring the receipt of compensation, and a commercial annuity is defined in section 3405(e)(6) as an annuity, endowment, or life insurance contract issued by an insurance company licensed to do business under the laws of any State.

Section 3405(e)(1)(B) identifies certain amounts or payments that are not a “designated distribution” for purposes of section 3405 withholding. Under section 3405(e)(1)(B)(iii), any amount that is subject to withholding under subchapter A of chapter 3 of the Code (relating to withholding of tax on nonresident aliens and foreign corporations) by the person paying such amount or which would be so subject but for a tax treaty is not a designated distribution.

Section 3405(e)(13)(A) provides generally that, in the case of any periodic payment or nonperiodic distribution that is “to be delivered outside of the United States and any possession of the United States,” no election may be made under section 3405(a)(2) or (b)(2) with respect to such payment, with the result that withholding may not be waived. Section 3405(e)(13)(B) provides that section 3405(e)(13)(A) does not apply if the recipient certifies to the payor, in such manner as the Secretary of the Treasury may prescribe, that the recipient is not (i) a United States citizen or a resident alien of the United States, or (ii) an individual to whom section 877 of the Code applies. Section 877(h) provides that section 877 applies to certain nonresident alien individuals whose expatriation date, as defined in section 877A(g)(3), is before June 17, 2008.

Notice 87-7, 1987-1 CB 420, provides guidance under section 3405(e)(13)(A) to payors of designated distributions with respect to their duty to withhold income tax from such distributions. The notice applies to designated distributions for the following categories of payees: (1) payees who have provided the payors with a residence address outside of the United States; (2) payees who have provided the payors with a residence address within the United States; and (3) payees who have not provided the payors with a residence address.

Notice 87-7 specifies that, if a payee has provided the payor with a residence address outside of the United States, the payor is required to withhold income tax from designated distributions to the payee. If a payee has provided the payor with a residence address within the United States, the payor is required to withhold income tax from these distributions to the payee unless the payee has elected no withholding in accordance with the applicable provisions of section 3405. If a payee has not provided the payor with a residence address, the payor is required to withhold income tax from designated distributions; included within this category is a payee who has provided the payor with an address for the payee's nominee, trustee, or agent without also providing the payee's residence address.

On May 31, 2019, the Department of the Treasury (Treasury Department) and the IRS published a notice of proposed rulemaking regarding withholding on certain periodic payments and nonperiodic distributions under section 3405 (other than eligible rollover distributions) in the Federal Register (84 FR 25209). No comments responsive to the notice of proposed rulemaking were received, and no public hearing was requested or held. Thus, this final regulation adopts the provisions of the proposed regulation with no modifications except for the change in the applicability date to January 1, 2026, and other minor changes in wording that are nonsubstantive.

Explanation of Provisions

This document contains a final regulation under section 3405(e) that provides withholding guidance for payors of periodic payments and nonperiodic distributions under section 3405(a) and (b), respectively. The regulation generally addresses a payor's obligation to withhold under section 3405(a) and (b) in the following situations: (1) payments to payees with a military or diplomatic Post Office address; (2) payments to payees with a residence address located within the United States; (3) payments to payees with a residence address located outside of the United States or who have not provided a residence address; and (4) payments subject to withholding under subchapter A of chapter 3 (sections 1441 through 1446 of the Code).

1. Payees With a Military or Diplomatic Post Office Address

For purposes of section 3405(e)(13)(A), the regulation treats an Army Post Office (APO), a Fleet Post Office (FPO), or a Diplomatic Post Office (DPO) address as an address located within the United States. In 1986, when this provision was added to the Code by the Tax Reform Act of 1986, Public Law 99-514 (TRA '86), it was one of several provisions intended to increase compliance with the internal revenue laws by United States persons resident abroad and green card holders. The Senate Finance Committee Report for TRA '86 indicates a concern, based on data gathered by the General Accounting Office (GAO), that the percentage of taxpayers who fail to file returns is substantially higher among Americans living abroad than it is among those resident in the United States, and that it is often difficult for the IRS to enforce compliance by these taxpayers. S. Rep. No. 99-313, at 390 (1986).

The GAO data referred to in the legislative history does not include United States military personnel and their families as taxpayers who are living abroad. Johnny C. Finch, United States Citizens Living in Foreign Countries and Not Filing Federal Income Tax Returns, United States General Accounting Office, May 8, 1985. In addition, enforcement of compliance by individuals receiving mail at an APO, an FPO, or a DPO address generally does not involve the same challenges as enforcing compliance by other taxpayers living abroad. Because APO, FPO, and DPO delivery destinations are generally United States military or diplomatic facilities, taxpayers with an APO, an FPO, or a DPO address commonly maintain a current or former employment or contractor relationship with the United States government. Moreover, these addresses generally are treated as “domestic” by the United States Postal Service. United States Domestic Mail Manual, 608.2.2.

For these reasons, the Treasury Department and the IRS have determined that treating a United States military or diplomatic post office address as located within the United States for purposes of section 3405(e)(13)(A) is consistent with the tax avoidance concerns underlying the enactment of that provision. Accordingly, the regulation provides that designated distributions to United States military and diplomatic personnel or their families are not treated as delivered outside of the United States solely because those payments or distributions are to be delivered to an APO, an FPO, or a DPO address.

2. Payees With a Residence Address Located Within the United States

The regulation imposes withholding requirements on payors regarding certain payees who have provided the payor with a residence address located within the United States. Under Notice 87-7, payors are not required to withhold if a payee provides a residence address located within the United States and the payee elects no withholding. Notice 87-7 does not specifically address whether payors are required to withhold when a payee provides a residence address located within the United States, but also provides payment instructions indicating that the funds are to be delivered outside of the United States. As explained in the Background section of this preamble, the mandatory withholding for amounts to be delivered outside of the United States was enacted because Congress was concerned about noncompliance. Section 3405(e)(13)(A) refers to “any periodic payment or nonperiodic distribution which is to be delivered outside of the United States.” Consistent with the text of section 3405(e)(13)(A) and its purpose, the regulation requires payors to withhold in certain circumstances when a payee provides a residence address located within the United States but also provides payment instructions indicating that the funds are to be delivered outside of the United States.

3. Payees With a Residence Address Located Outside of the United States or Who Have Not Provided a Residence Address

Unless section 3405(e)(13)(B) (which provides an exception for certain nonresident aliens) applies, if the payee's residence address that is provided to the payor is located outside of the United States, the payor is required to withhold income tax under section 3405 from any designated distribution, without regard to the delivery instructions and without regard to any attempt to elect no withholding. Thus, for example, withholding under section 3405 would be required even if a payee with a foreign residence address has requested that the distribution be deposited with a financial institution located within the United States. Given the ease with which the funds deposited with a financial institution in the United States can be withdrawn by a person located outside the United States, the Treasury Department and the IRS have concluded that the payee's residence address is more likely to be indicative of the place the distribution is ultimately to be delivered than the location of the financial institution. The same requirement to withhold income tax under section 3405 applies if a payee has not provided a residence address to the payor. Furthermore, a payee who has provided the payor with an address for the payee's nominee, trustee, or agent without also providing the payee's residence address has not provided a residence address for purposes of this regulation.

These rules are consistent with the approach in Notice 87-7, which uses the residence address of the payee in order to determine whether a taxpayer is permitted to make an election not to have withholding apply under section 3405(a)(2) or (b)(2). The Treasury Department and the IRS have determined that this interpretation articulated in Notice 87-7 provides an administrable standard that has been relied upon for many years, is consistent with the TRA '86 legislative history, and appropriately addresses tax avoidance concerns underlying section 3405(e)(13)(A).

4. Payments Subject to Withholding Under Subchapter A of Chapter 3

In accordance with section 3405(e)(1)(B)(iii), the regulation clarifies that a designated distribution does not include a distribution that is subject to withholding under subchapter A of chapter 3 (or that would be subject but for a tax treaty). Therefore, the withholding rules under section 3405(a) and (b) do not apply to such a distribution. For example, section 3405(a) or (b) withholding would not apply to a United States-source distribution to a nonresident alien individual from a trust described in section 401(a) of the Code. In such a case, the withholding rules of section 1441 (within subchapter A of chapter 3) that apply to nonresident aliens would apply to such a distribution. See § 1.1441-1(b)(1).

Applicability Date

This regulation applies with respect to payments and distributions made on or after January 1, 2026. However, taxpayers may apply the regulation to earlier payments and distributions. Notice 87-7 is obsoleted with respect to payments and distributions made after December 31, 2025.

Statement of Availability of IRS Documents

The IRS notice cited in this preamble is published in the Cumulative Bulletin and is available from the Superintendent of Documents, U.S. Government Publishing Office, Washington, DC 20402.

Special Analyses

I. Regulatory Planning and Review

Pursuant to the Memorandum of Agreement, Review of Treasury Regulations under Executive Order 12866 (June 9, 2023), tax regulatory actions issued by the IRS are not subject to the requirements of section 6 of Executive Order 12866, as amended. Therefore, a regulatory impact assessment is not required.

II. Paperwork Reduction Act

The collection of information related to the withholding requirements is captured within the forms and instructions for Forms W-4P and W-4R. Both of these forms are approved under OMB Number 1545-0074. This regulation does not alter any previously approved information collection requirements contained within the forms and instructions for Forms W-4P and W-4R, and this regulation does not create new collection requirements not already approved by the Office of Management and Budget.

III. Regulatory Flexibility Act

Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6) it is hereby certified that the collection of information in this regulation will not have a significant economic impact on a substantial number of small entities. The number of small entities potentially affected by this regulation is unknown but could be substantial because based on data and information available to the Treasury Department and the IRS, most defined benefit and defined contribution retirement plans are sponsored by small employers (defined as employers with fewer than 100 employees), while annuities and IRAs are typically set up by large financial institutions. Although a substantial number of small entities is potentially affected by this regulation, the Treasury Department and the IRS have concluded that this regulation will not have a significant economic impact on a substantial number of small entities. This is because the main purpose and effect of this regulation is to treat military and diplomatic post office addresses the same as residence addresses located within the United States for purposes of income tax withholding, and payors of distributions from retirement plans and annuities are already processing distributions to payees with residence addresses located within the United States. Accordingly, this regulation will not have a significant economic impact on a substantial number of small entities. Therefore, a regulatory flexibility analysis under the Regulatory Flexibility Act is not required.

Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding this regulation was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

IV. Unfunded Mandates Reform Act

Section 202 of the Unfunded Mandates Reform Act of 1995 requires that agencies assess anticipated costs and benefits and take certain other actions before issuing a final rule that includes any Federal mandate that may result in expenditures in any one year by a state, local, or tribal government, in the aggregate, or by the private sector, of $100 million in 1995 dollars, updated annually for inflation. This regulation does not include any Federal mandate that may result in expenditures by state, local, or tribal governments, or by the private sector in excess of that threshold.

V. Executive Order 13132: Federalism

Executive Order 13132 (Federalism) prohibits an agency from publishing any rule that has federalism implications if the rule either imposes substantial, direct compliance costs on state and local governments, and is not required by statute, or preempts state law, unless the agency meets the consultation and funding requirements of section 6 of the Executive Order. This rule does not have federalism implications and does not impose substantial direct compliance costs on state and local governments or preempt state law within the meaning of the Executive Order.

VI. Congressional Review Act

Pursuant to the Congressional Review Act (5 U.S.C. 801 et seq.), the Office of Information and Regulatory Affairs designated this rule as not a major rule, as defined by 5 U.S.C. 804(2).

Drafting Information

The principal author of this regulation is Jeremy Lamb, of the IRS Office of Associate Chief Counsel (Employee Benefits, Exempt Organizations, and Employment Taxes (EEE)). However, other personnel from the Treasury Department and the IRS participated in the development of the regulation.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 31 is amended as follows:

Paragraph 1. The authority citation for part 31 continues to read in part as follows:

Authority: 26 U.S.C. 7805.

Par. 2. Section 31.3405(e)-1 is added to read as follows:

[FR Doc. 2024-24224 Filed 10-18-24; 8:45 am]

BILLING CODE 4830-01-P