Special Tax Treatment for Employer Stock

The Beach Boys said it best. Rah, rah, rah, be true to your school. In that spirit, the Tax Code grants special tax benefits to investment of your employer retirement plan account in stock of your employer. These tax goodies were enacted before anyone ever heard of Enron.

A reader has asked an arcane question about qualifying for this special tax treatment. I’ll get to that tomorrow when I discuss how to qualify. For today, I will first focus on just what that tax treatment is.

Here’s the deal, in a nutshell. If you receive a distribution of employer stock from your employer’s tax-favored retirement plan, and that stock has appreciated in value since the plan bought it, you can pay tax on just a portion of the distribution—i.e., the amount the stock cost the trustee of the plan—and defer tax on the appreciation until you actually sell the stock. Upon that sale, the appreciation is taxed as long-term capital gain, often at a lower rate than ordinary income. (That balance is called Net Unrealized Appreciation, or NUA for short, and the special tax deal is sometimes called “NUA treatment” by the jargonistas.)

For the interested, here’s a summary of the whole picture:
• The amount currently subject to income tax is not the fair market value of the employer stock. Rather it is the original cost to the plan of the employer stock, which might be a fraction of its value, particularly if you have been a plan participant for many years, and much of the stock was purchased a long time ago. Unfortunately, just about everybody has experienced a bad case of NUA shrinkage over the last year or so.
• The plan trustee will report both the stock’s original cost and its fair market value to you on a Form 1099-R at the time of the distribution.
• Taxation of the difference between the current fair market value and the plan’s original cost—the stock’s NUA—is delayed until you sell the stock.
• Your tax basis in the employer stock is its fair market value, reduced by the NUA. In other words, your tax basis is the amount you paid tax on.
• When you sell the stock, you are entitled to treat the NUA as long-term capital gain regardless of how long you (or the employer retirement plan) have held the stock. Long-term capital gain is often taxed at a lower rate than ordinary income.
• Any additional appreciation between the date of distribution and the date of a later stock sale is treated as long- or short-term capital gain, depending on how long you have held the stock, measured from the date the retirement plan distributed it to you.
• If you are under age 59-1/2 at the time of the stock distribution, you will be subject to a 10% penalty tax on the stock’s original cost, unless an exception applies, as discussed in February 19’s post. You will not be subject to the 10% penalty tax on the NUA, even if you sell the stock before age 59-1/2.
• If the lump sum distribution includes cash as well as employer stock, you may roll over the cash in a tax-free rollover, and enjoy NUA treatment on the stock.
• Or you may roll over the employer stock to an IRA or other tax-favored retirement plan, foregoing NUA treatment in favor of continued tax deferral.
• You may also roll over part of the employer stock and take NUA treatment on the balance.
• If you die still holding the employer stock, the NUA is taxed to your heirs (as long-term capital gain) when they sell the stock. They do not get a new stepped up tax basis in that part of the stock’s appreciation, as they do with other appreciated assets.
• If you are entitled to NUA treatment, you don’t have to take it. You may waive it, typically by opting instead to roll over the stock to a traditional IRA, or by paying ordinary income tax on the distribution.

So that’s it in a nutshell. Tomorrow I will discuss the requirements for qualifying for this deal. And in a later post, I’ll discuss how to determine whether to take advantage of it. It’s often not as good a deal as it’s cracked up to be.