The ERISA consultants at the Learning Center Resource Desk, which is available through Columbia Threadneedle Investments, regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. A recent call with an advisor in Texas is representative of a common inquiry regarding the special tax treatment for net unrealized appreciation (NUA) associated with distributed employer stock. The advisor asked:
“Can participants in an S-Corporation’s employee stock ownership plan (ESOP) take advantage of the special tax treatment for NUA associated with distributed employer stock?”
Discussion
The answer is, potentially.
Under applicable rules, with some exceptions, an ESOP must specifically provide a participant, who is entitled to a distribution, the right to demand that his or her benefits be distributed in the form of employer securities [IRC §409(h)(1)(A)].
One exception to this requirement is when the employer is an S-Corporation, in which case the plan may require distributions be made in cash [IRC §409(h)(2)]. If the plan requires distributions in cash only, then the special tax treatment for NUA in employer securities would not be available to distribution recipients since one of several qualifying requirements is the receipt of employer stock in kind. (Please see the IRS's Topic 412-Lump Sum Distributions and ESOP Examining Process for additional details.)
Assuming the S-Corp’s ESOP permits distribution in-kind of the stock shares, the plan must give a participant the right to require the employer to repurchase the securities pursuant to a fair valuation formula (a “put option”) for at least 60 days following the date of distribution. If the put option is not exercised within that period, the employer must provide an additional period of at least 60 days in the following plan year during which the employee may exercise a put option [IRC §409(h)(1)(b) and (h)(4)]. However, the plan document could require the put option to be “immediate,” in order to protect the S-Corporation election under the 100 shareholder limitation. Therefore, it is important to review the plan document provisions as they will prevail.
The IRS has addressed the immediate repurchase issue for S-Corporations in Revenue Procedure (Rev. Proc.) 2003-23 and Rev. Proc. 2004-14. These revenue procedures provide that an S-corporation’s election is not affected as a result of an ESOP’s distribution of S-Corporation stock in a direct rollover to an IRA if the terms of the ESOP require that the S-Corporation repurchase its stock immediately upon the ESOP’s distribution of the stock to the IRA, the S corporation actually repurchases the stock, and the other requirements of that revenue procedure are satisfied.
An IRS technical memorandum further clarified that an immediate repurchase requirement addressed in Rev. Procs. 2003-23 and 2004-14 also applies to situations where the distribution of stock is made to a participant (and not directly to an IRA). It is important to review the terms of the plan document with respect to the distribution and immediate repurchase of the stock, as the document must specifically address this procedure. (The following excerpt is from the above referenced technical memo.)
“ … plans maintained by an S corporation … which provide for the distribution of employer securities subject to immediate resale to the employer or in appropriate cases to the ESOP (i.e., “mandatory repurchase”) are consistent with the statutory framework of section 409(h). This is without regard to whether the distribution is made to a participant or as a direct rollover to an IRA. Because the participant in such plan does not have the right to demand employer securities to begin with, there is no abuse when such right is not extended to the participant upon the distribution of employer securities. Rather, these provisions give the distributee the added benefit of capital gains treatment on the proceeds of the mandatory repurchase which exceeds the cost basis of the distributed stock (i.e., the net unrealized appreciation). See section 1.402(a)-1(b)(1) of the Income Tax Regulations (“Regulations”).
If an S corporation … desires to provide for the distribution from an ESOP of employer securities subject to immediate resale to the employer, the plan must contain applicable language to so provide.
Conclusion
When dealing with an ESOP maintained by an S-Corporation and the question of whether the special tax treatment for NUA applies, to start, I would suggest a thorough analysis of the sections of the plan document that relate to the stock distribution and repurchase provisions of the plan. The provisions of the plan will determine whether participants may be able to take advantage of the tax advantaged afforded NUA, if other requirements are met.
The Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC (RLC), a third-party industry consultant that is not affiliated with Columbia Threadneedle. Any information provided is for informational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Columbia Threadneedle does not provide tax or legal advice. Consumers consult with their tax advisor or attorney regarding their specific situation.
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