Some ESOPs permit participants to take a lump sum distribution from their accounts. Some may provide an option for all or a portion of the distribution to be paid in shares of Employer stock.
Why would Joe want to take his distribution in shares of his company’s stock? If his stock has appreciated in value while in his ESOP account, there may be a tax advantage. Joe may be able to pay ordinary income tax on the cost basis of the shares, if that basis is less than the current fair market value of the shares. Later, when Joe sells the shares, he can pay tax at capital gains rates on the value of the proceeds that exceed the original cost basis.
Joe is 64 years old and retired from the company last year.
Joe has 25,000 shares of stock in his ESOP account with a cost basis of $1.00 per share. If his employer is a C corporation, this is the original cost basis of the shares when they were acquired by the ESOP. Today his stock is worth $4.00 per share, and that represents a total of $100,000 in potential taxable income subject to tax at ordinary income tax rates if he takes a distribution in cash.
Instead Joe takes a taxable distribution in stock and then immediately sells those shares for $100,000. He can elect to have the cost basis of $25,000 taxed as ordinary income and the “net unrealized appreciation (NUA)” of $75,000 taxed as a capital gain. For many taxpayers, there could be a considerable tax savings from the application of a capital gains rate to the net unrealized appreciation of the shares distributed.
What if the company stock ownership is restricted and the shares cannot be held by individuals?
The ESOP document might permit Joe to receive a stock distribution subject to an immediate put or sale back to the Employer. Then Joe would be eligible for the tax benefits associated with NUA tax treatment.
If the company is an S Corporation, the cost basis of the shares is adjusted annually based on certain income, loss and deduction items listed on the Schedule K-1 provided to the ESOP. In that case it is important for the ESOP to maintain accurate adjusted cost basis records.
There are a number of conditions that a plan participant must meet in order for his distribution to be considered to be a “lump sum” distribution for special NUA tax treatment. The distribution must consist of his entire vested balance and be distributed within one taxable year of the employee. The distribution must be payable on account of the employee’s death, after the employee attains age 59 ½, on account of the employee’s separation from service, or after the employee has become disabled. Furthermore, when considering whether his entire vested account was distributed from a pension plan, profit sharing plan or stock bonus plan, all stock bonus plans of the employer are treated as a single plan, all pension plans of an employer are treated as a single plan and all profit sharing plans of an employer are treated as a single plan.
In summary, the tax treatment associated with the distribution of appreciated stock can provide a significant tax benefit to a participant who elects to pay ordinary income tax on the cost basis or adjusted cost basis) of the shares.