Net unrealized appreciation.

• Author: Gibson, Daniel J.

Under Sec. 402(e)(4)(A), special rules and capital-gain treatment are available when a qualified retirement plan's lump-sum distribution (LSD) is composed, either in whole or in part, of the employer corporation's securities. Under those rules, employees are not taxed on the net unrealized appreciation (NUA) on the distribution, under Sec. 402(a) and (e)(4)(B). Regs. Sec. 1.402(a)-1(b)(2)(i) defines NUA as the excess of the aggregate fair market value (FMV) of the securities on the distribution date over their aggregate cost or other basis to the plan.

How It Works

According to Sec. 402(e)(4)(B), NUA in an LSD of an employer's securities is excluded from the recipient's gross income. It could also be excluded from income under Sec. 402(e)(4)(D) (discussed below), even if the employee has not been a plan participant for five years. The amount that the recipient includes in income (i.e., the FMV less the NUA) is taxed under the LSD rules (normally, as ordinary income to the employee, if not rolled over, and subject to the 10% penalty if no Sec. 72(t) exceptions apply). The plan's basis in employer securities distributed to the employee is the amount included in the employee's gross income.

When employer securities are sold after distribution, any gain realized is long-term capital gain to the extent attributable to NUA not taxed at the time of receipt. Under Regs. Sec. 1.402(a)-1(b)(1)(i)(b) and Notice 98-24, any gain in excess of this amount is long- or short-term capital gain, depending on how long a taxpayer holds the securities after the distribution. For this purpose, the taxpayer's holding period begins on the day after the securities are delivered to the transfer agent with instructions to reissue the stock in the taxpayer's name; see Rev. Rul. 82-75 and Letter Ruling 8724049. This basis is used when computing gain of loss on a subsequent disposition of the shares.

Rolling over part of an LSD does not affect the favorable tax treatment allowed for the NUA on employer stock that the taxpayer retained; see Letter Ruling 9721036. Thus, a taxpayer who receives an LSD comprising both cash and appreciated employer stock can roll over all or part of the cash portion into an IRA and retain the appreciated employer stock, without affecting favorable tax treatment. However, the FMV less the NUA would be subject to ordinary tax rates and a potential 10% penalty for early distribution.

Example 1: S leaves her job in 2004 and receives an LSD from...