Qualifying for Special Tax Treatment for Employer Stock

In yesterday’s post I described special tax treatment that applies to certain distributions of employer stock from your employer’s retirement plan. But I didn’t say how to qualify for this deal. Having dealt with the cart, I will now get back to the horse. What conditions do you have to meet to qualify? Here they are in a nutshell.

• The distribution must be from a qualified plan, i.e., a plan that meets all the arcane qualification requirements for tax-favored status under the Tax Code. That includes 401(k) plans, profit sharing plans, and money purchase pension plans. It does not include Individual Retirement Accounts, 403(b) plans and 457 plans.
• The sponsoring employer must be a corporation.
• Some or all of the distribution must be in the form of stock in the employer.
• The distribution must have been made after or on account of one of the following events:

• On account of your death
• After you have attained age 59-1/2
• On account of your separation from service with the employer.

• You must not have rolled over the employer stock to an IRA. Once you do a rollover, that amounts to an irrevocable election not to take NUA treatment on the stock rolled over.
• The qualified plan must distribute the entire balance of your account.
• If your employer maintains two or more plans of the same type, you must also receive the entire balance of your account under any qualified plan of the same type maintained by your employer.

That last requirement sounds pretty mystifying. It also gets to a question raised by a reader. Here’s a little bit of explanation. The Tax Code recognizes three “types” of qualified retirement plans for purposes of meeting that last requirement. They are: (i) pension plans, (ii) profit sharing plans, and (iii) stock bonus plans. (To make your life difficult, the IRS has said that a qualified plan might fall into two types at once.)

The specific question a reader asked, in a comment to February 19’s post, is which “type” does an ESOP fall into. That question is either easy to answer or it’s hard. An “ESOP,” or Employee Stock Ownership Plan, in the strict Tax Code-defined sense of the word, must either be a money purchase pension plan (unusual) or a stock bonus plan (more typical). It can’t be a profit sharing plan. Easy answer.

Now here’s the hard part. People often use the term “ESOP’ in a looser sense. Like Humpty Dumpty, they use words to mean what they want. And you might sometimes hear a profit sharing plan that’s designed to invest in employer stock referred to as an “ESOP” in which case it falls into the profit sharing type, just like a 401(k) plan. In that case, an employee would have to receive lump sum distributions from both the 401(k) plan and the Humpty Dumpty "ESOP" to qualify for NUA treatment. The bottom line: If you get a lump sum distribution from your employer’s “ESOP”, and the employer also maintains a 401(k) plan, better ask the employer whether the “ESOP” is a stock bonus plan, a profit sharing plan, or both.

One other clarification. In her comment, the reader slightly misstated the requirement in the last bullet point. She wrote, “it's my understanding that you must take a lump sum distribution from all qualified plans of that employer in the same calendar year in order to receive NUA treatment on the select shares. This includes pension, profit sharing and stock bonus plans.” That’s not quite right. You don’t need to take lump sum distributions from all qualified plans to be entitled to NUA treatment—just qualified plans of the same type. So if you get a lump sum distribution from a stock bonus plan, and leave your account sitting in the 401(k) profit sharing plan, you can still qualify for NUA treatment on the employer securities included in the stock bonus plan distribution.

Whew! I’m glad I cleared that up. I haven’t been able to sleep.

Tomorrow, I’ll discuss the pros and cons of taking NUA treatment.