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The cost basis of any type of stock is essential to recordkeeping. It’s needed to calculate and document any gain or loss in share value, as well as the timing of that gain or loss, for tax purposes.

As a qualified retirement plan, an employee stock ownership plan (ESOP) allocates company stock to employee plan participants over time, and employees receive distributions when they leave the company.

When employees receive ESOP distributions, there are tax consequences to consider. Distributions may be paid in company stock, cash, or a combination, in a lump sum or substantially equal payments over a specified period of time.

If the employee has the choice between cash and stock, the option to elect net unrealized appreciation (NUA) treatment of the stock may provide the employee a tax advantage.

Let’s take a closer look at the importance of accurate, up-to-date tracking and documentation of the cost basis of employee shares.

What is the Cost Basis?

The cost basis of a share is the original value of that share when it was purchased. In the case of an ESOP, the original cost basis of an employer security in the ESOP is the value of the stock when it was deposited into the ESOP trust. Because ESOP share values are determined annually, that computation is pretty straightforward.

Why Does the ESOP Cost Basis Matter?

The tax responsibility of the participant receiving an ESOP distribution can differ depending on whether the distribution is received as stock or cash.

A cash distribution, if not rolled over into an individual retirement account or other qualified plan, is subject to ordinary income tax rates for the tax year in which it is received.

On the other hand, if a distribution is received as shares which the participant then sells back to the company, the cost basis of the shares would be taxable as ordinary income.

If the current fair market value of the stock is higher than the cost basis, this is known as Net Unrealized Appreciation (NUA), and that difference is taxed at the long term capital gains rate. The taxation of NUA at the long term capital gains rate at the time of distribution is without regard for how long the distributed stock was held in the plan before distribution.

NUA election is an option for lump-sum ESOP stock distributions of a participant’s entire account within a single tax year, as a result of the employee attaining age 59-½, becoming disabled, dying, or termination of employment.

This is important for ESOP participants to understand if they receive a distribution in the form of shares. The timing of their exercise of the put option (i.e. when they opt to sell the shares back) could result in additional NUA if the shares’ value appreciates between the distribution and the time of sale

That additional NUA, above the cost basis plus NUA at distribution, would be subject to taxation at the short term capital gains rate.

In most cases, the participant’s stock put occurs immediately after the distribution, using the prior plan year-end fair market value, so the case of additional NUA after distribution is pretty uncommon. Nevertheless it’s important to track cost basis to accurately determine the NUA on an ESOP stock distribution.

It may be important for participants to understand that rolling a stock distribution over can eliminate the option of capital gains tax treatment, since the eventual IRA distribution will be taxed as ordinary income. That’s not to say that NUA election is always the best option. It’s important to run the numbers to make a determination, and the numbers are different for every individual.

How to Calculate Cost Basis for Your ESOP

Internal Revenue Code (IRC) Sec. 1.402(a)-1(b)(2)(ii) cites four methods that can be used to compute the cost basis of employer securities in the ESOP:

  • Earmarking Method
  • 12-month Allocation Method
  • Single Security Type Method
  • Average Cost Method

The IRC regulations go into detail clarifying the applicability and use cases of the four methods of calculating the cost basis of ESOP securities.

Cost Basis Considerations and Your ESOP Distribution Policy

A quick review of the IRC regulations makes it clear that accurate cost basis records are an important part of any ESOP plan’s documents.

That said, keeping accurate cost basis records for individual ESOP participants can quickly become complicated. This is especially true if multiple stock transactions take place during the life of the ESOP — and if those shares have not been tracked in separate accounts, segregated by transaction.

You should be able to trust your third-party administrator (TPA) to accurately track, adjust, and document the cost basis of allocations in participant accounts as part of the services they provide.

It’s also important for ESOPs to articulate their distribution policies in plan documents. Some opt for a policy of all cash distributions; others may always issue distributions in the form of stock; a third option could point to the participant’s or ESOP’s choice in the form and payment of distributions.

If the shares for distribution have a low cost basis compared to current value, allowing plan participants the option of electing NUA could enable them to make use of favorable tax treatment. That could improve the impact of the benefit on the participant’s financial security in retirement. If the plan gives participants the choice, they should review their options with their tax consultant before taking the distribution.

The Role of an Experienced TPA

It’s hard to overstate the importance of accurate, detailed recordkeeping down to the individual participant level. It’s also tough to overstate how quickly that recordkeeping can become complicated and overwhelming to someone without significant experience and expertise in ESOP planning and administration.

A trusted ESOP expert should be part of initial planning and documentation, to set up your program for not only compliance, but also relative ease in operation — and just as important, employee satisfaction. With the right support and expert guidance, an ESOP can be a transformational benefit to the selling business owner, to the company itself, and to individual employees.

You can learn more about the wide-ranging rewards of employee ownership when you download our free eBook, Key Benefits of Incorporating an ESOP in Your Business Exit Strategy. Click the link below to claim your copy.New call-to-action

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