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Lump Sum Distribution of Employer Securities

There exists a little known tax break that can help clients reduce taxes on employer securities held in a tax deferred retirement plan. Many publicly held companies, such as Procter & Gamble and General Electric, use employer stock to fund their employees' retirement plans. If employer's stock is held inside a tax deferred retirement plan, an extremely attractive tax break exists under Internal Revenue Code Section 402. The tax break is available for company securities held in both the Procter & Gamble Profit Sharing Trust and Employee Stock Ownership Plan as well as the G.E. Savings and Security Plan.

We will call this tax break the net unrealized appreciation (NUA) tax break. The opportunity for using the NUA tax break comes into play when an employee retires or otherwise separates from service after reaching age 55. The employee need not be retiring or age 59 1/2 - the NUA tax break is also available to an employee who is simply separating from the service of his employer and is 55 years of age. It is also usually available to a retired employee who currently wishes to take a lump sum distribution from the company's retirement plan.

The employee can withdraw the employer's stock from the plan in a lump sum distribution and pay income tax immediately. What's so great about this you may ask. As unappealing as this may sound, such a move can save a significant amount of tax.

Under Code Section 402, when employer securities are withdrawn in kind from the plan under this provision, taxes are paid only on the original cost of the shares to the employer. This may be quite low if the employee has been in the plan for many years. Income tax is paid at ordinary income tax rates only on the original cost basis of the securities at the time they were placed in the plan. All subsequent stock appreciation experienced within the plan won't be taxed until the securities are sold by the now departed employee. Long term capital gains rates will apply.

The more appreciation which has occurred in employer securities, the more valuable this tax break becomes.

For example, suppose Jane Jones has accumulated 1,000 shares of her employer's stock now trading at $100.00 per share. Jane wants to retire. If those shares are liquidated in the plan as part of the retirement process and she pulls the $100,000.00 out of the plan in cash, she will owe up to 39.6% in federal taxes on the full $100,000.00 which she receives.

She could roll the account balance over into an Individual Retirement Account - but the money would be fully taxable whenever it is withdrawn. Anything other than lump sum tax treatment upon separation using NUA rules obviates long term capital gains treatment.

If Jane withdraws the securities from the plan in kind, income tax will only be paid on the value of the stock at the time the contributions were made. If the average cost of the 1,000 shares contributed into the plan was $10.00 per share, then Jane would have $10,000.00 in ordinary taxable income in the year of the lump sum distribution. With the lump sum distribution and the payment of income tax, Jane would hold $100,000.00 worth of employer stock (1,000 shares) outside of the plan. She could hold on to the shares and keep deferring the tax or she could sell the shares and upon sale of the shares, the NUA ($90,000.00) would qualify for the 20% rate for long term capital gains. The securities need not all be sold at the same time. She simply has a cost basis of $10.00 per share for any subsequent stock sale.

Additionally, all appreciation from the date of distribution to the date of sale would also qualify for long term capital gains rate providing the stock is held for the additional required long term capital gain holding period (one year from the distribution date). The IRS has ruled that the gain on net unrealized appreciation is taxed at capital gains rate even if the stock is sold the day after distribution to the employee. Capital gains treatment of further appreciation, however, requires holding the stock for the long term capital gains holding period.

Sometimes implementing this strategy is difficult. Some publicly held companies know very little about the NUA tax break and don't know how to properly report such a distribution. The result, in these cases, is an employer Form 1099-R (Distributions from Profit Sharing Plans and IRAs) sent to the employee and the IRS which creates Form 1040 reporting issues and potential tax problems.

Some companies, like Procter & Gamble and General Electric, are quite knowledgeable about the NUA tax break and are very helpful. Obtaining the cost basis of the employer's stock in an employee's account is readily available. This cost basis information is the key to a proper reporting of the lump sum distribution of employer securities on Form 1099-R and NUA tax break.

This is a sometimes misunderstood section of the tax code. Simply reading employer plans and IRS publications on lump sum distributions would leave one to believe that the NUA tax break may be unavailable.

It is this practitioner's experience that many attorneys, accountants and other advisors do not understand the NUA tax break. Additionally, administrators of publicly held companies, in many instances, do not have a good understanding of NUA nor good internal information with regard to employer cost basis for employer securities contributed on behalf of the employee.

If a client is interested in the NUA strategy, she should begin addressing this strategy within the company many months before the distribution is requested.