Net unrealized appreciation.

Under Sec. 402(e)(4)(A), special rules and capital-gain treatment are available when a qualified retirement plan's lump-sum distribution (LSD) is composed, either in whole or in part, of the employer corporation's securities. Under those rules, employees are not taxed on the net unrealized appreciation (NUA) on the distribution, under Sec. 402(a) and (e)(4)(B). Regs. Sec. 1.402(a)-1(b)(2)(i) defines NUA as the excess of the aggregate fair market value (FMV) of the securities on the distribution date over their aggregate cost or other basis to the plan.

How It Works

According to Sec. 402(e)(4)(B), NUA in an LSD of an employer's securities is excluded from the recipient's gross income. It could also be excluded from income under Sec. 402(e)(4)(D) (discussed below), even if the employee has not been a plan participant for five years. The amount that the recipient includes in income (i.e., the FMV less the NUA) is taxed under the LSD rules (normally, as ordinary income to the employee, if not rolled over, and subject to the 10% penalty if no Sec. 72(t) exceptions apply). The plan's basis in employer securities distributed to the employee is the amount included in the employee's gross income.

When employer securities are sold after distribution, any gain realized is long-term capital gain to the extent attributable to NUA not taxed at the time of receipt. Under Regs. Sec. 1.402(a)-1(b)(1)(i)(b) and Notice 98-24, any gain in excess of this amount is long- or short-term capital gain, depending on how long a taxpayer holds the securities after the distribution. For this purpose, the taxpayer's holding period begins on the day after the securities are delivered to the transfer agent with instructions to reissue the stock in the taxpayer's name; see Rev. Rul. 82-75 and Letter Ruling 8724049. This basis is used when computing gain of loss on a subsequent disposition of the shares.

Rolling over part of an LSD does not affect the favorable tax treatment allowed for the NUA on employer stock that the taxpayer retained; see Letter Ruling 9721036. Thus, a taxpayer who receives an LSD comprising both cash and appreciated employer stock can roll over all or part of the cash portion into an IRA and retain the appreciated employer stock, without affecting favorable tax treatment. However, the FMV less the NUA would be subject to ordinary tax rates and a potential 10% penalty for early distribution.

Example 1: S leaves her job in 2004 and receives an LSD from her employer's Sec. 401(k) plan when she is age 50. The distribution comprises $200,000 cash and $100,000 of employer stock. The original cost basis of the distributed stock is $10,000. Thus, $90,000 of NUA is attributable to the stock ($100,000-$10,000). S rolls over the $200,000 into an IRA and keeps the stock. As a result, she pays income tax plus the 10% early distribution penalty on only the $10,000 stock basis. She then continues to defer tax on the $90,000 NUA on the stock.

When S sells the stock, the first $90,000 of gain will be taxed as long-term capital gain. Any additional appreciation in the stock at that time will also receive capital-gain treatment and be long of short-term, depending on whether S has held the stock for more than a year.

Example 2: The facts are the same as in Example 1, except that, rather than keeping the stock, S rolls over the entire $300,000 LSD into an IRA in 2004. She pays no income tax or early distribution penalty, but cannot use the long-term capital gain rate on any subsequent distributions from the IRA, because the $90,000 of NUA loses its long-term capital gain status and becomes ordinary income when distributed from the IRA.

By not rolling over the appreciated stock into an IRA, S pays a relatively minor amount of income tax and penalty, in exchange for receiving favorable long-term capital gain treatment in the future.

Other Considerations

Before taking a distribution, taxpayers would be wise to consider the following: Favorable tax treatment for employer securities applies only to an LSD. If a distribution is not part of an LSD, the securities' full FMV would generally be included in income. Besides, a distribution would qualify as a lump sum only if it includes the entire "balance to the credit of an employee," according to Sec. 402(c)(4) (D)(i). Under Sec. 402(c)(4)(D), an LSD is a payment within one tax year of the entire amount becoming payable to a recipient:

1. On account of the employee's death;

2. After the employee attains age 59 1/2;

3. In the case of a common law employee, on account of separation from the employer's service; or

4. In the case of a self-employed person, after he or she has become disabled.

Plan termination is not a triggering event; sec Clark, 101 TC 215 (1993). Plan administrators must give notice of the exclusion of NUA before making distributions, including employer securities, according to Sec. 402(f).

Separation from Service

Cases and rulings in this area generally agree that no separation from service occurs when an employer transfers its business in a reorganization or sale and a distributee becomes an employee of the transferee, even if the plan terminates in connection with the transfer. In Gittens, 49 TC 419 (1968), the transferee carried on the same business, with substantially the same staff, including the distributee. Rev. Rul. 79-336 states that a separation from service occurs only on an employee's death, retirement, resignation or discharge, and not when he or she continues in the same job for a different employer after the original employer liquidated, merged, etc.

In Reinhardt, 85 TC 511 (1985), there was no separation of a physician-employee of a professional corporation, who terminated the employment relationship but continued to perform the same services as an independent contractor.

Based on the above, a cash-for-stock transaction appears, either in whole of in part, to have an unfavorable effect on the capital gain treatment of the employer stock in a profit-sharing plan. Simply put, the employer stock would now be cash and subject to ordinary tax rates when distributed. Any employees who would be eligible for an LSD should take it prior to the transaction, to avail themselves of the favorable capital gain treatment.

The strategy of separating from service only to be rehired by an acquirer should be scrutinized--the IRS could make a substance-over-form argument and subject the NUA to ordinary tax rates.

Recommendation

With a stock for-stock transaction, favorable tax treatment would appear to continue. The acquiree's stock would be exchanged for the acquirer's stock; when the LSD is made, the acquirer's stock would be employer securities that could take advantage of the capital gain rates.

FROM DANIEL J. GIBSON, CPA, EA, AMPER, POLITZINER & MATTIA, P.C., EDISON, NJ