Tracking tax basis in an S Corp. ESOP.

• Author: Rempalski, Kristy L.
• Position: Employee stock ownership plans

Employee stock ownership plans (ESOPs) currently cover 10 million employees in the U.S. participating in approximately 11,000 plans, according to the ESOP Association. With the number of plans expected to increase, the need for tax accounting and recordkeeping for ESOPs is becoming more prevalent and complex. Although much has been written about the general workings of these plans, the tax benefits to the company, and the potential for increased employee loyalty by implementing an ESOP, this item focuses on another ESOP issue: how to track the employee's tax basis in his or her ESOP stock.

A participating employee in an ESOP receives company stock as an employee benefit, which he or she accumulates over time and which serves as a form of retirement savings. An employee is not taxed on the current accumulation of wealth in company stock, only when the stock or funds are withdrawn from the ESOE similar to a 401(k) plan. Distributions may be paid in a lump sum or in substantially periodic payments. The plan documents will specify if the distribution of ESOP benefits may be paid in cash or company stock. When an employee leaves the company, an agreement traditionally obligates the employer to buy back the distributed stock at fair market value (FMV). Unless the ESOP is part of a publicly traded company, an annual valuation is required to determine the price of their shares.

On a lump-sum distribution of employer securities, an employee will defer any tax relating to net unrealized appreciation (NUA) under Sec. 402(e) (4)(B) until the underlying securities are disposed of. Alternatively, the employee may elect to be taxed currently on any NUA on the tax return in which the lump-sum distribution is reported. Employees receiving lump-sum distributions in 2010 who are not required to immediately sell back the employer stock may want to consider making the election (due to the impending tax rate change for capital gains). Regs. Sec. 1.402(a)-1(b)(2)(i) defines NUA as the excess of the employer securities' FMV at the distribution date over their cost or other basis to the qualified plan's trustee. The individual is taxed on NUA at long-term capital gains rates, regardless of the ESOP's holding period for the shares distributed and the individual's holding period once the securities are distributed. If the employer securities are not roiled over tax free to a qualified plan, an employee must recognize as ordinary income his or her basis in the shares...