Since IRC Section 4975(e)(7) requires ESOPs be primarily invested in employer securities and participants may be entitled to stock distributions, electing Net Unrealized Appreciation (NUA) on a stock distribution should be considered before taking a distribution from the plan.
What is NUA?
As outlined in Treas. Reg. §1.402(a)-1(b)(2), NUA is “the excess of the market value of such securities at the time of distribution over the cost or other basis of such securities to the trust.”
As a result, a participant will need to know what the cost basis of the stock is in order to determine the NUA amount. Most ESOP administration firms will track the cost basis of the stock in the ESOP as part of their recordkeeping services.
What are the requirements?
In order to elect NUA, certain provisions must be met as noted in IRC Section 402(e)(4):
The distribution must be made from a qualified plan, such as an ESOP
The distribution has to be in the form of stock
The stock must be distributed to the participant (not rolled over to an IRA or another qualified plan)
The distribution must be a lump sum distribution
The distribution must occur after age 59½, death, disability or termination of employment
What is the benefit?
The amount of NUA is not taxed at the time of the distribution and only the cost basis of the stock is taxed at the individual’s ordinary income tax rate. When the shares are eventually put (or sold) back to the corporation, the NUA amount is taxed as long term capital gain. IRS Notice 98-24 confirms the NUA is taxed at the long term capital gain rate, regardless of the time the stock was held in the plan.
At the time of the stock sale, there may be additional taxable appreciation if the stock is sold for a value above the value at the time of the ESOP distribution. The value in excess of the cost basis and NUA of the stock will be taxed as short term capital gain if the individual held the stock for less than 12 months, or long term capital gain if the individual held the stock for more than 12 months. Since most stock puts occur right after the stock distribution using the prior plan year end fair market value, additional taxable appreciation is not common.
If the stock in the ESOP has a low cost basis compared to the current value of the stock, it is highly recommended to allow participants to have the option of electing NUA. The NUA tax benefit should be reviewed by the individual and their tax consultant prior to taking a distribution from an ESOP, as well as by the Plan Sponsor in the ESOP Distribution Policy planning process.