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Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers. Here’s the question of the day.

Question: What is an Employee Stock Ownership Plan (ESOP)?

Answer: An employee stock ownership plan (ESOP) is a special kind of defined contribution retirement plan that can help closely-held business owners solve succession issues. Where it fits, an ESOP offers substantial advantages over traditional buy-sell planning. The main advantage is that the business owners and the company are able to fund a buyout with pre-tax money.

Unlike other retirement plans, an ESOP is required to invest primarily in the sponsoring company’s securities. Most often, the securities take the form of the company’s common stock.

To set up an ESOP, the sponsoring company first needs to create a pension trust, into which shares of the company stock will go.

The employer might contribute new shares of its own stock into the trust, or it may contribute cash to buy existing shares. The ESOP plan might be empowered to borrow money to buy additional shares, with future employer contributions anticipated to repay the loan. If the ESOP trust borrows money to buy shares, it can borrow funds backed by the credit of the sponsoring company. Further, company contributions to the ESOP trust are deductible, both for the loan principal and loan interest.

Shares owned by the trust are in turn allocated to individual employee accounts, as with most kinds of defined contribution plans. Plan allocation formulas must not discriminate in favor of highly compensated employees, and are typically based on employee compensation.

When an employee leaves the company, the employee receives either the stock from the employee’s account, or an amount of cash equal to the value of the stock. If stock is distributed, the plan document requires the company to buy back ESOP stock from the employee at its fair market value.

Distributions from ESOPs are generally taxed the same way as distributions from other qualified plans. For example, distributions prior to age 59½, death, or disability are usually subject to a 10% penalty. ESOP distributions, when turned into cash, are generally eligible for rollover.

In addition to the tax deduction generated, the ESOP also offers extra tax advantages to owners of closely held C corporations. Most shareholders of C corporations can sell stock to the ESOP, and reinvest the proceeds, with all taxes deferred, by making a Section 1042 election.

The C corporation owner can elect to defer capital gains tax on stock sold to the ESOP if

After the sale the ESOP owns 30% or more of all outstanding stock; and

The seller reinvests an amount equal to the sale proceeds into qualified replacement property, during the period beginning three months before and ending twelve months after the sale to the ESOP.

Not all eligible owners of C corporations will elect tax deferral under Code Section 1042. Making the choice will depend on a variety of factors, including the seller’s current and expected future capital gains tax rates.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Question of the Day – October 17

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: My client owns employer stock in his pension account. I have heard that he can get favorable tax treatment on the distribution of that stock. How does that work?

Answer: A pension participant may be able to take advantage of the Net Unrealized Appreciation (NUA) rules. When the plan trustee purchases employer stock for a participant’s account, the price paid becomes the cost basis. At the time of distribution, a positive difference between the cost basis and fair market value is NUA.

For example, suppose employer stock is purchased for a participant’s account at a cost of $10 per share. At the participant’s retirement, the stock has a fair market value of $50 per share. The NUA is $40 per share.

If the participant takes a distribution of the employer stock as part of a complete qualified plan distribution and immediately sells the stock, it gets favorable tax treatment as follows: the cost basis ($10 per share in our example) is taxed as ordinary income, while the NUA ($40 per share in our example), is taxed as long-term capital gain. For taxpayers in the highest tax bracket, paying at long-term capital gains rate can mean substantial tax savings.

If the participant liquidates the qualified account and holds the stock rather than selling, ordinary income tax must be paid on the cost basis in the year of distribution. Upon a later sale, the participant will owe capital gains tax on the NUA.

If the participant rolled over the entire account balance to an IRA instead, 100% of any distributions to the IRA would be subject to ordinary income tax at the highest individual tax bracket. Employer stock that is rolled over to an IRA loses favorable tax treatment and is treated as any other IRA investment. This is true even if the stock is rolled over as an in-kind distribution. In essence, rolling over employer stock with NUA to an IRA converts capital gains into ordinary income.

Distributions from a qualified plan are subject to a 10% penalty unless on account of death, disability, attainment of age 59-1/2, or separation from service after attaining age 55. The 10% penalty applies only to the ordinary income portion the distribution.

The favorable tax treatment of employer stock can be helpful in these circumstances. Suppose, in our example, the participant has 1,000 shares of employer stock with a cost basis of $10 and fair market value of $50. If the stock is taken as a LSD prior to age 55 and immediately sold, the participant would owe tax on the cost basis at, say, 35% plus a 10% penalty. This would be 45% times $10,000 or $4,500. The tax on the NUA would be 15% times $40,000 or $6,000, for a total tax of $10,500. The 10% penalty does not apply to NUA. Contrast this with a LSD of $50,000 cash where the tax would be 45% times $50,000, or $22,500.

When a client owns employer stock inside a 401(k) plan or an ESOP, it’s smart to pay attention to any NUA. In many cases, it’s in the client’s income tax interest to leave the money in the 401(k) plan rather than transfer to an IRA.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Question of the Day – June 13

Question of the Day – October 17