Tracking tax basis in an S Corp. ESOP.

Employee stock ownership plans (ESOPs) currently cover 10 million employees in the U.S. participating in approximately 11,000 plans, according to the ESOP Association. With the number of plans expected to increase, the need for tax accounting and recordkeeping for ESOPs is becoming more prevalent and complex. Although much has been written about the general workings of these plans, the tax benefits to the company, and the potential for increased employee loyalty by implementing an ESOP, this item focuses on another ESOP issue: how to track the employee's tax basis in his or her ESOP stock.

A participating employee in an ESOP receives company stock as an employee benefit, which he or she accumulates over time and which serves as a form of retirement savings. An employee is not taxed on the current accumulation of wealth in company stock, only when the stock or funds are withdrawn from the ESOE similar to a 401(k) plan. Distributions may be paid in a lump sum or in substantially periodic payments. The plan documents will specify if the distribution of ESOP benefits may be paid in cash or company stock. When an employee leaves the company, an agreement traditionally obligates the employer to buy back the distributed stock at fair market value (FMV). Unless the ESOP is part of a publicly traded company, an annual valuation is required to determine the price of their shares.

On a lump-sum distribution of employer securities, an employee will defer any tax relating to net unrealized appreciation (NUA) under Sec. 402(e) (4)(B) until the underlying securities are disposed of. Alternatively, the employee may elect to be taxed currently on any NUA on the tax return in which the lump-sum distribution is reported. Employees receiving lump-sum distributions in 2010 who are not required to immediately sell back the employer stock may want to consider making the election (due to the impending tax rate change for capital gains). Regs. Sec. 1.402(a)-1(b)(2)(i) defines NUA as the excess of the employer securities' FMV at the distribution date over their cost or other basis to the qualified plan's trustee. The individual is taxed on NUA at long-term capital gains rates, regardless of the ESOP's holding period for the shares distributed and the individual's holding period once the securities are distributed. If the employer securities are not roiled over tax free to a qualified plan, an employee must recognize as ordinary income his or her basis in the shares received.

Four methods are provided in Regs. Sec. 1.402(a)-1(b)(2)(ii) for determining the cost or other basis in the employer securities. If a security was earmarked for an employee's account at the time it was released to the account of the employee, such cost or other basis will be used. When employer securities were purchased during the tax year, or other period not exceeding 12 months, and allocated to more than one employee, the average cost can be used as the security cost. The final two remaining options relate to employer securities that were not tracked or allocated to individual employee accounts.

Rev. Rul. 2003-27 states that the stock of an S corporation held by an ESOP is subject to the same basis adjustments under Sec. 1367(a) as stock held by any other S shareholder. The stock's NUA is determined using the ESOP's adjusted basis in the stock. However, the basis of a share of stock to the plan for purposes of determining NUA does not control its basis in the hands of the distributee. The distributee's basis will be the same for each share of stock received.

Third-party administrators (TPAs) who traditionally provide benefit plan services for ESOPs will track the allocation of shares to each participant's account in the respective plan and generally the original cost basis of the shares. However, TPAs do not generally track the basis under Sec. 1366(a)(1) for an ESOP-owned S corporation, and therefore the responsibility generally falls to the S corporation's tax advisers. Under Sec. 1366 (a)(1), an S shareholder must take into account all items of income, loss, deduction, or credit and allocate the items on a pro-rata basis to each share of the corporation. It is the corporation's responsibility to request the TPA to track this for all participants in its ESOP plan, including providing the TPA with a Schedule K-1, Shareholder's Share of Current-Year Income, Deductions, Credits, etc., each year to allocate the appropriate share of income or loss. TPAs will determine if they have adequate knowledge of Sec. 1366(a)(1) to properly track the stock basis. If an employee with a significant ownership in the plan retires or is distributed stock, the tax ramifications are much easier to compute when information has been tracked since the plan's inception. If the plan allows for only cash distributions, there should be no need to track basis under Sec. 1366(a)(1).

The following example illustrates how the stock basis in employer securities would be computed for an individual employee and the tax impact when the securities are distributed.

Example: Z, a calendar-year S corporation, maintains Plan B, an ESOP. Plan B holds 100 shares of Z stock purchased on January 1, 2006, for $20,000 with employer contributions. Plan B's pro-rata share of Z's taxable income for tax year 2006 is $5,000, or $50 per share; for tax year 2007 it is $1,000, or $10 per share. There are no Sec. 1366(a)(1) adjustments other than for taxable income.

A is an employee of Z and an eligible participant in Plan B. Five shares are maintained in Plan B for A's benefit from January 1, 2006, to December 31, 2007. On the latter date, Plan B distributes to A five shares of Z stock, which is required to be repurchased under a fair-valuation formula in accordance with Sec. 409(h). On December 31, 2007, the FMV of the five shares is $1,500. As shown in the exhibit above, in the year of distribution, the FMV of A's shares is $1,500, their basis is $1,300, and A's NUA is $200.

A could elect under Sec. 402(e) (4)(B) to forgo the deferral of tax on the NUA and pay tax on the NUA of employer securities distributed. If the employer securities are not repurchased under Notice 98-24, the IRS holds that any gain on the subsequent sale of stock not rolled over is taxed as long-term capital gain to the extent of the original NUA, regardless of the sale date. In determining whether to make the election, factors to consider include current long-term capital gain tax rates versus ordinary rates, speculation on future tax rates, cashflow to pay the tax due, and speculation on the stock performance over time. In addition, unless the distributed stock is roiled over to an eligible retirement plan in accordance with Sec. 402(c), $1,300 of ordinary income will be recognized in the year of distribution.

This example is simplified and does not take into account employee and employer contributions. If the employee contributes cash or property, the calculation will differ and the NUA will need to be allocated among employee and employer contributions in the plan.

Many employees are unaware of the tax implications and consequences when receiving ESOP distributions. With proper recordkeeping and basis tracking, the ESOE the company, and the TPA will be able to readily provide the employee with adequate information to determine the tax consequences of plan distributions. This allow employees to make informed decisions about taking a lump-sum distribution, rolling over the proceeds to another qualified retirement plan, and other considerations. With employees continuously entering and exiting a retirement plan, it is essential to keep records up to date to ensure that the proper basis and records are maintained on each employee's behalf.

FROM KRISTY L. REMPALSKI, CPA, AND MATTHEW C. OSTERHAVEN, CPA, GRAND RAPIDS, MI

Exhibit: A's shares of Z stock--FMV,
basis, and NUA

                                               Per Share

Original basis of stock purchased
  with employer contributions                       $200
Plan B's pro-rata share of Z's 2006
  income                                              50
Plan B's pro-rata share of Z's 2007
  income                                              10

A's basis per share in employer securities          $260

FMV at Dec. 31, 2007, of securities
  distributed                                     $1,500
A's basis in distributed shares                    1,300

NUA                                                 $200