Making Sense of ESOP Net Unrealized Appreciation Rules
Dec. 22, 2017
By Aaron L. Geibel and Peter J. Shuler
Employee stock ownership plans (ESOPs) and other qualified retirement plans invested primarily in employer securities offer unique tax advantages for participants receiving a plan distribution. The IRC allows advantageous tax treatment on stock distributions paid from qualified retirement plans, and the difference can be significant.
How It Works
In order to avoid taxation at the time of a distribution, participants can roll over their distribution into an individual retirement account (IRA) or other qualified retirement plan. If a participant elects to have the distribution paid directly to him or herself and the distribution is made in cash, those payments will be subject to ordinary income tax rates, which currently range from 10 percent to 39.6 percent. However, if direct distributions from a plan are paid in the form of stock, a portion of the distribution is taxed at a lower rate. Specifically, the net unrealized appreciation (NUA) of the stock at the time of distribution is taxed at long-term capital gains rates, currently 20 percent and generally much lower than most participants’ ordinary income tax rates. Only the cost basis of the stock is taxed at the participant’s ordinary income tax rate.
NUA is the difference between the cost basis of the employer stock being distributed and the fair market value of that stock at the time of distribution. If a qualified retirement plan purchased employer stock, the cost basis of that stock is the amount the plan paid for it. If the plan sponsor contributed the stock, the cost basis is the fair market value at the time it was contributed. The cost basis of ESOP S-corporation stock must be adjusted annually in the same manner it is adjusted for non-ESOP shareholders. Third-party administrators should be able to track and adjust the cost basis in individual participant accounts as a part of their recordkeeping services.
NUA tax treatment is not available for all distributions. In order to qualify, the participant must receive a lump-sum stock distribution of his or her entire account within one tax year, and the participant must not roll that distribution over to another qualified plan or IRA. Additionally, the distribution must occur following one of these events: the participant’s death, the attainment of age 59 ½, termination from employment, or disability.
NUA Example Scenario
The following example illustrates the application and significance of NUA tax treatment. Assume the 50 shares in an ESOP participant’s account originally were purchased for $100, which equals a total cost basis of $5,000. The ESOP participant elects a distribution when his or her ESOP account balance contains 50 shares worth $500 per share, for a total account value of $25,000 and NUA of $20,000 ($25,000 total value less $5,000 cost basis). The participant is in the 30 percent income tax bracket.
If the distribution is paid in cash, the participant would pay $7,500 in taxes ($25,000 x 30 percent) and, if the participant is younger than 59 ½, an additional 10 percent early withdrawal penalty of $2,500 ($25,000 x 10 percent) would apply. However, if the same distribution is paid in the form of stock and is not rolled over, just the cost basis would be taxed at 30 percent. The NUA would be taxed at 20 percent. The participant’s total tax liability would be $5,500 (($5,000 x 30 percent) + ($20,000 x 20 percent)). If the participant is younger than 59 ½, the 10 percent early withdrawal penalty would be assessed on only the cost basis of the shares ($5,000 x 10 percent, or $500). In this instance, a stock distribution yields a savings of $2,000 ($7,500 less $5,500) if the participant is at least 59 ½ years of age and $4,000 ($10,000 less $6,000) if the participant is younger than 59 ½.
For most privately held ESOPs, it is not necessary to physically distribute a stock certificate to the participant during the payment process. Participants generally immediately sell the shares back to the company (or the ESOP) and receive cash. As such, the NUA tax treatment is available with little change in the logistics of the distribution. ESOP plan administrators, however, should verify that the distribution forms clearly indicate that the participant is receiving a stock distribution from the plan and immediately selling it back to the employer.
In some cases, the company sponsoring the ESOP decides whether participants will be offered distributions in the form of stock or cash. In others, both forms are offered, and the participant can elect the form of distribution. Whether the company or the participant is making that choice, the special tax treatment provided for stock distributions should be one of the factors considered and discussed with an attorney, accountant, and third-party administrator.