Taxing employer securities.

The Taxpayer Relief Act of 1997 created two different tax rates for all long-term capital gains: a 20% rate for assets held for more than 18 months and a 28% rate for assets held for more than 12, but not more than 18 months. However, the 1997 act did not specify which rate would apply to "net unrealized appreciation." This no longer is a mystery. According to IRS Notice 98-24 (1998-17 IRB), net unrealized appreciation will be taxed at the lowest capital gain rate of 20%.

A net unrealized appreciation occurs when a qualified retirement plan invests in employer securities that increase in value after they are purchased by a trust. According to IRC section 402(e)(4)(B), if the employer securities are distributed as part of a lump-sum distribution, the taxable amount does not include the net unrealized appreciation. However, the net realized appreciation is taxed as a long-term capital gain when the securities are sold. Any additional gain will be either long- or short-term depending on how long the taxpayer holds the securities from the distribution date to the date of sale.

Under the new rate, taxpayers do not have to calculate the actual holding. All such securities will be considered to be held by the trust for more than 18 months prior to any distribution. This is a tremendous taxpayer victory and it will save CPAs hours of tedious work.

Observation: The guidance in Notice 98-24 applies to sales of employer securities that occur (1) after May 6, 1997, and (2) before January 1, 2001, or the date further guidance is issued, whichever is later. Beginning 2001, the capital gains rates for traded securities that have been held for more than five years will be reduced.

Michael Lynch, CPA, Esq., associate professor of tax accounting at Bryant College, Smithfield, Rhode Island.