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Last October we discussed technical advice memorandum (TAM) 200841042, which confirmed that ESOP Stock Distributions Subject to Immediate Put Option to Company are Stock Distributions eligible for net unrealized appreciation (NUA) treatment. One of the biggest takeaways from this TAM is the documentation of a distribution process accepted by the IRS. While the documented distribution process has been helpful, questions have come up about the process of issuing and cancelling stock certificates. The distribution process discussed in the TAM involved cancelling the Plan's stock certificate, issuing new certificates to the Plan and to the participant, and then cancelling the participant's stock certificate upon redemption of the shares by the company. The TAM also cited IRS Revenue Ruling 81-158, 1981-1 C.B. 205 - Taxability of beneficiary under a trust which meets the requirements of section 401(a), which provides that a profit sharing distribution occurs upon the delivery of stock certificates to a transfer agent with instructions to reissue them in the name of the distributee.

Should you go through the process of issuing and cancelling stock certificates for each stock distribution? Be Careful to Preserve Beneficial Taxation of ESOP Stock Distributions provides another perspective on the TAM and some takeaways that address the stock certificate issue:

1. It is important to make ESOP stock distributions very carefully, so that the special taxation method is preserved for a former employee who wants to report the "net unrealized appreciation" as a capital gain and pay a lower rate of tax, in lieu of an IRA rollover.

2
. It is not necessary to physically distribute a stock certificate to the former employee, if he immediately sells the stock back to the employer. However, it is crucial that the ESOP, the distribution documents and the operating procedures clearly provide that the employee is receiving stock from the ESOP and is immediately selling the stock to the employer.

3. The ruling DOES NOT consider the situation where the ESOP itself purchases the stock from the terminated employee, instead of a purchase by the employer. There is some language in the ruling that implies a sale back to the ESOP would not be eligible for the special method of taxation without first issuing the stock certificate to the employee. Therefore, if the ESOP is purchasing the stock from a terminated employee, and the employee will not be rolling over to an IRA, best practice would be to actually issue a stock certificate to the terminated employee which will then be immediately sold back to the ESOP.

4. What your ESOP and the distribution documents say (and don't say) can be crucial in preserving beneficial tax advantages for the ESOP participants. Those administering the ESOP may have a fiduciary duty to assure the special taxation method is preserved. Your ESOP and distribution documents should be reviewed in light of this IRS ruling.

While issuing and cancelling stock certificates for each stock distribution may end up being overkill and unnecessary, if you want to take a conservative approach, you should consider implementing the best practice of issuing and cancelling stock certificates. At a minimum, you should discuss your stock distribution procedures with an ESOP consultant or attorney.

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