Taxability of lump-sum ESOP distributions at employment termination.

In Villaroel, TC Memo 1998-247, a taxpayer terminated her employment with Oral B Laboratories (a subsidiary of the Gillette Company) in October 1994, after more than five years of service. Due to her length of employment, she had been eligible to participate in Gillette's employee stock ownership plan (ESOP) and was fully vested. Gillette had made contributions to the ESOP on her behalf; she was not permitted to make any contributions. On termination of her employment, the taxpayer elected to receive a lump-sum distribution of her entire ESOP account, consisting of shares of Gillette's common stock and accumulated dividends; the distribution had a fair market value (FMV) of about $22,300. The taxpayer subsequently sold a portion of the shares in late 1994 for $6,114. She included the entire sale proceeds as capital gain on her 1994 tax return, but not did not report the distribution.

The taxpayer argued that her account in Gillette's ESOP was not a "retirement account," because it was "set up without her knowledge or consent," and she had "no choice in participating" in the plan. No documentation was given to support this position. In fact, the taxpayer had received letters as an ESOP participant from the plan along with other correspondence. These letters and other documents allowed the court to determine that the ESOP was a qualified stock bonus plan. Generally, an amount distributed from a qualified stock bonus plan, less the amount of any contributions made by the distributee (here, zero), is taxable to the distributee in the year made. However, the net unrealized appreciation (NUA) attributable to securities that the employer received is excluded from the taxpayer's current taxable income. Because the taxpayer's distribution was comprised almost entirely of Gillette common stock and the phrase "securities of the employer corporation" includes shares of stock of a parent or subsidiary corporation of the employer, this exception applied. The NUA, or the difference between the stock's FMV at the time of distribution and the basis, was calculated as approximately $13,000. Therefore, the taxpayer was required to include in her gross income the portion of the distribution not attributable to the NUA (approximately $9,300).

Under Sec. 72(t), any amount received from a qualified retirement plan is subject to an additional 10% tax on the portion of the distribution includible in gross income, unless certain exceptions are met (e.g., over age 59 1/2). Qualified stock bonus plans, such as the Gillette ESOP, are included in the definition of qualified retirement plans. Because the taxpayer met none of the exceptions under Sec. 72(t), the additional tax was assessed.

The proceeds on the sale of stock exceeded its basis, resulting in a gain included in the taxpayer's gross income. After determining the taxpayer's per-share basis and the number of shares sold, the adjusted basis in the shares sold was $2,471, resulting in a $3,643 gain on the sale. The amount of the gain pertaining to NUA was treated as a gain from a capital asset held for more than one year, thus qualifying for long-term capital gain treatment. Any gain in excess of NUA was taxed as a short-term capital gain, because the taxpayer had held the securities for less than one year following the distribution. Because the stock's FMV increased between the distribution date and date of sale, short-term capital gain treatment was allocated for that portion of the gain (calculated at $113). The remainder of the gain ($3,530) was taxed as long-term.

If a client is terminating employment, advice on whether to take shares of stock or cash from a plan, roll over a distribution or keep the proceeds, or whether a distribution is required at all, can often result in significant savings.