net unrealized appreciation (NUA)

[Guest kurt johansen]

I have a client who used his account under a DC plan to purchase a substantial share of the stock of a start-up company several years ago. The client then left the old company to run the start-up and has built it into a successful company. The old company is terminating its plan and the client wants to know whether he should roll the stock over into an IRA or into his DC plan in the start-up. Assuming the stock will appreciate over the next few years, can we take advantage of the net unrealized appreciation rule of IRC 402(e) to avoid future appreciation? Should we consider a transfer to an IRA and then a Roth coversion?

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[Guest Harry O]

There are too many variables and not enough information in your post to offer any useful observations.

Stuff you need to think about:

1. If stock is not rolled over, he'll pay income tax (and the 10% penalty tax if under 59.5) on the basis. Rollover obviously defers these taxes.

2. If stock not rolled over, he'll pay tax on any dividends. If the stock pays a healthy dividend, it may make sense to roll it over to an IRA to defer tax.

3. If stock not rolled over, he'll pay tax on any gains realized upon sale. If he thinks he may want to diversify out of this position, he'll do so in a taxable manner. Rolling the stock allows for tax-deferred diversification (at the cost of the loss of the capital gains treatment--but if your client is relatively young this is no big deal).

4. Roth conversion only makes sense if he expects to be in higher tax bracket and can pay conversion tax with other assets. It may also make sense if he doesn't think he'll ever need to sell the stock to fund his retirement years. Roth IRAs have no minimum distribution requirements so he can let the IRA grow untouched past 70 1/2 and upon his death payments can be made tax-free over the life expectancy of his heirs. Roth IRAs have other nice estate tax benefits as well . . .

5. There is no "step-up" in basis for the NUA if he dies holding the stock.

Just some top-of-the-head thoughts. My advice is to sit your client down with a good financial planner who *really* understands the NUA and Roth rules. ****YOU SIMPLY NEED TO RUN THE NUMBERS TO COMPARE ALL THE ALTERNATIVES****

[Guest Noel C Ice]

Does anyone know the meaning of the last sentence of 402(e)(4)(A)? I have studied and thought about it for hours, and obviously must be mentally challenged, because I have no real idea what it means.

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Noel C. Ice

www.trustsandestates.net

teleice@Dtrustsandestates.net

[Guest Noel C Ice]

Despite the fact that I have recently written on this subject in some detail, I do not have a good feel for all of the issues involved with net unrealized appreciation (NUA) in employer stock. In fact the reason that I just added a long chapter to my treatise on this subject is I had the issue come up, and I decided to find all of the rules that I could and reduce them to writing for future reference. This is not something that comes up every day and I was afraid that I would forget what I learned, which has proven to be the case.

I direct you to www.trustsandestates.net, where you will find a link on the first page to my treatise. Look at Article VII, Income Tax Issues, Section K, In Kind Distributions of Employer Securities.

[Guest Harry O]

>Does anyone know the meaning of the >last sentence of 402(e)(4)(A)?

This section deals with NUA attributable to *employee* contributions. The last sentence is saying that the NUA exclusion in the case of employee contributions is not available if *any* portion of the distribution is rolled over. Note that this restriction does not apply to NUA attributable to employer contributions in 402(e)(4)(B). The legislative history to UCA '92 changes is sparse but there is some good explanations of what many of these changes were meant to do in subsequent technical corrections bills which were never enacted(!).

[Guest kurt johansen]

Thanks Noel, I checked your treatise and it is very informative.

My original message may not have made clear my situation. My client, Employee X, worked for Company A. Employee X directed the trustee of his Company A 401(k) Plan to buy stock in Company B (about 5% of the company's stock). Now Employee X works for Company B and the Company A 401(k) Plan is terminating. If Company B stock is transferred to Company B's 401(k) Plan, can Employee A benefit by the NUA rules? I don't think so because the stock was not purchased while Employee X was an employee of Company B. Furthermore, there is no basis for the rollover in Company B 401(k) Plan (although arguably fair market value at the time of the rollover could be used).

Company B is a small company and is not publicly traded. Employee X is contemplating entering into a buy/sale agreement with respect to his stock. Assuming the stock is held in the Company B 401(k) Plan, I am concerned that this would be a prohibited transaction between the Plan and Plan Sponsor. The exeception for the sale of stock for fair market value would be lost by the buy/sale agreement. For this reason, I am leaning toward advising a transfer to an IRA.

Any thoughts on either of these issues would be appreciated.

[Guest Noel C Ice]

Thanks Harry for your answer to the question of what the last sentence of 402(e)(4)(A) means: “This subparagraph shall not apply to a distribution to which subsection © [i.e., 402©(?), rollovers] applies.” This has puzzled me for the longest time, and still does.

For starters, I note that t here is no counterpart to this sentence under 402(e)(4)(B), which gives nonrecognition treatment for the NUA in employer securities attributable employee (and employer, for that matter) contributions distributed in lump sum. Further, it is clear that the IRS will allow a distributee to roll over assets other than employee securities received in a lump sum distribution, preserving NUA treatment in the securities not rolled over. PLR 9721036.

A very important threshold question is whether this sentence applies to a distribution any portion of which is rolled over, or only to that portion of a distribution that is rolled over? Harry suggests that the last sentence of 402(e)(4)(A) means that if any portion of a non lump sum distribution of employer securities attributable to employee contributions is rolled over, then what would have been appreciation in the employer securities will have to be recognized. The sentence could be clearer on this point, but I am inclined to agree with the suggested interpretation, because other interpretations do not make sense.

Employee contributions (other than DECs) may not be rolled over in the first place. DECs may be rolled over, but 402(e)(4)(A) expressly does not apply to DECs. However, even though an employee’s contributions cannot be rolled over, the increase or growth in excess of basis can be rolled over.

Is it possible to make a partial rollover that includes employer securities attributable to employee contributions, if the total value of the rollover does not exceed the employer contributions? Certainly, if the distribution were in any other form of property, a portion of which was attributable to employer contributions, it would be permissible to rollover property equal to the employer contributions, withholding the difference from the rollover. In fact, this is how it is usually done in the case of a cash distribution. The regulations are clear that, if the plan allows for it, the plan may allocate employee contributions among various properties distributed to the distributee, if assets other than employer securities are a part of the distribution. Thus, some employer securities, having in effect no NUA at the time of distribution, could be rolled over. These securities could be available for distribution later, after they had appreciated.

So maybe this sentence simply means that if employer securities attributable to nondeductible employee contributions have been rolled over, in a rollover of an amount that does not exceed the employer’s portion of the total value of a non lump sum distribution, any subsequent distribution of those securities will be fully taxable without regard to the special deferral rules otherwise applicable with respect to the NUA. Is statutory language necessary to reach that result? Does a different rule apply under 402(e)(4)(B) in the case of a rollover of a lump sum distribution?

At this point, I favor the first interpretation; namely, that if there is any rollover, then NUA treatment is not available, at least with respect to any stock not rolled over. But what if employer stock is rolled over to a qualified plan of the employer —which can be done now, but probably could not have been done when the statute was enacted because non lump sum distribution were generally not subject to rollover? If the stock rolled over is not attributable to employee contributions, I would think that the appreciation would qualify for NUA treatment if later distributed in a lump sum distribution.

[Guest Noel C Ice]

This is partial response to Kurt’s last post.

This is also my third attempt to edit it. For some reason everything in the paragraph that had the words 49 percent got truncated. I suspect that the text editor does not like the percent sign, so I am spelling it out this time and trying again.

The more I study this area, the more fascinating it becomes.

I don’t really see, from just looking at the IRC, that it ought to make much difference who acquires the securities. If the securities meet the definition of employer securities under the statute, the favorable tax results should follow.

“The term ‘securities’ means only shares of stock and bonds or debentures issued by a corporation with interest coupons or in registered form.” IRC §402(d)(4)(E)(i). “The term ‘securities of the employer corporation’ includes securities of a parent or subsidiary corporation (as defined in subsections (e) and (f) of section 424) of the employer corporation.” IRC §402(d)(4)(E)(ii).

As for the prohibited transaction question, that is a little tricky. My experience is that you have to examine all PT questions very carefully, because the result is often counter intuitive. See Article XI of my treatise (found on my website, www.TrustsAndEstates.net). As an example as an aside, I think that a sale or purchase between an IRA and a business entity owned by a spouse or other family member is outside the scope of the per se prohibitions under the PT rules, even if the IRA owner owns 49 percent of the business! Anyone have any thoughts on that? I am not looking for general thoughts, I am looking for thoughts with a specific reference to a specific provision of 4975. (See 4972(d)(2)(E) and the flush language of 4972(d)(2).)

Back to your point, however, I think you are right that a transaction between the plan and the employer would be a prohibited transaction on its face under IRC §4975© and ERISA 406. But IRC §4975(d) provides that “the prohibitions provided in subsection © shall not apply to— . . . (13) any transaction which is exempt from section 406 of such Act by reason of section 408(e) of such Act (or which would be so exempt if such section 406 applied to such transaction),” and ERISA §408(e) provides that “Sections 406 and 407 shall not apply to the acquisition or sale by a plan of qualifying employer securities . . . if . . . ” So, I would not assume that you are necessarily prohibited from doing what you contemplate. Of course, a definitive opinion would require a much more in depth analysis, but I hope the foregoing is of some help.

(Incidentally, the challenge of keeping cites in 402 up to date is almost too much. It is not enough that cites that used to be to (d) are now to (e) (or is it vice-versa), but the effective date provisions are such that reading this statute is like a MENSA membership examination, which I am sure I would flunk.)

[Note: This message has been edited by Noel C Ice]

[Guest Harry O]

Noel,

I spend mucho time in the NUA provisions (as well as the rest of 402) as a result of my job. I agree that the NUA provisions are quite interesting.

Anyway, my observations:

"Further, it is clear that the IRS will allow a distributee to roll over assets other than employee securities received in a lump sum distribution, preserving NUA treatment in the securities not rolled over. PLR 9721036."

I would just add that the distributee can even roll over some of the employer securities to an IRA without forfeiting NUA treatment on the remaining shares.

"Is it possible to make a partial rollover that includes employer securities attributable to employee contributions, if the total value of the rollover does not exceed the employer contributions?"

Certainly but you forfeit NUA treatment on the remaining shares.

"The regulations are clear that, if the plan allows for it, the plan may allocate employee contributions among various properties distributed to the distributee, if assets other than employer securities are a part of the distribution. Thus, some employer securities, having in effect no NUA at the time of distribution, could be rolled over. These securities could be available for distribution later, after they had appreciated."

I'm not sure I followed all this. Are you suggesting that the employer securities rolled over into another employer's plan or an IRA can be later distributed and eligible for NUA? If so, that is not the case. Once employer securities are rolled over into another employer's plan or an IRA, the NUA game is over. A subsequent distribution of the securties is fully and immediately taxable (subject, of course, to another rollover transaction.)

"But what if employer stock is rolled over to a qualified plan of the employer —which can be done now, but probably could not have been done when the statute was enacted because non lump sum distribution were generally not subject to rollover? If the stock rolled over is not attributable to employee contributions, I would think that the appreciation would qualify for NUA treatment if later distributed in a lump sum distribution."

Rolled over to which employer's plan. Again, a rollover transaction to a plan not sponsored by the employer corporation or an IRA forfeits NUA treatment.

P.S. Another interesting NUA "play" when employee contributions are present in a LSD is to rollover all cash and employer securities to an IRA EXCEPT an amount of employer securities with a basis equal to the amount of nontaxable employee contributions. These employee contributions "cover" the taxable basis of the retained securities and the NUA is nontaxable under 402(e)(4)(B). Thus, all of the retained stock is nontaxable. You apparently can even allocate employee contributions in this manner even if you keep some cash as well. See 402©(6)©.

[Guest Noel C Ice]

Harry,

What is your job that causes you to know so much about NUA and 402? You are obviously very knowledgeable on the subject, and I am therefore glad to know about you. I am new to this message board, and so haven’t figured out how to check your profile, if it is available. I was wondering if you could e-mail me at teleice@trustsandestates.net with your email address.

Regarding your last post, I understood that Kurt’s client X works for company A, but invests his account in company B. X is now going to work for B, and wants to roll over his account to a QP with B. That is why the rollover account will contain “employer stock.” This is obviously an unusual situation. You are right to emphasize that in the usual situation the NUA game will end if the stock is rolled over.

You quoted the following from my post

“The regulations are clear that, if the plan allows for it, the plan may allocate employee contributions among various properties distributed to the distributee, if assets other than employer securities are a part of the distribution. Treas. Reg. §1.402(a)-1(B)(2)(ii). Thus, some employer securities, having in effect no NUA at the time of distribution, could be rolled over. These securities could be available for distribution later, after they had appreciated.”

In my confused way, I was posing the example as a situation for which the last sentence of 402(e)(4)(A) might have been seeking to prevent favorable tax treatment. I didn’t think much of this interpretation because I felt that NUA would not be an issue following a rollover anyway, even under 402(e)(4)(B). I like your suggestion better; viz., that the last sentence simply means that if any amount is rolled over the NUA in the amount not rolled over will be recognized. Why this is the rule, and why only under 402(e)(4)(A) is still a mystery, particularly since the situation would be so easy to manipulate by having non lump sum distributions in more than one year.

You next quoted the following from my post and asked “which employer.”

“At this point, I favor the first interpretation; namely, that if there is any rollover, then NUA treatment is not available, at least with respect to any stock not rolled over. But what if employer stock is rolled over to a qualified plan of the employer —which can be done now, but probably could not have been done when the statute was enacted because non lump sum distribution were generally not subject to rollover? If the stock rolled over is not attributable to employee contributions, I would think that the appreciation would qualify for NUA treatment if later distributed in a lump sum distribution.”

I was thinking of Kurt’s situation, and was definitely considering that the securities would be in the stock of the employer sponsor of the rollover plan. What I am thinking is that in his case, his account with company A has company B stock in it. If he rolls to company B it becomes employer stock (we think). It has a zero basis, assuming as I was, that it is not attributable to employee contributions. For NUA purposes, however, I would guess that the appreciation would be measured as the excess of future distribution value over FMV at the time of rollover, but this basis question is beyond me at this point, though I am intrigued by it. There may be something in the regs. on basis determination that prevents Kurt’s plan from working.

However, nothing (other than the plan’s terms) should prevent Kurt from simply rolling over cash to the company B plan, and then investing in company B stock. Simply rolling the stock over in the first place ought to be treated as functionally the same, which, by the bye, means that there is no real advantage to his plan. This last point is key.

Your last observation about 402©(6)© was terrific. I was thinking that the allocation had to be done by the plan, but a quick reading of this statute suggests that it is all up to the taxpayer, and this could prove very helpful.

All in all, I think that there are a lot more planning opportunities with employer stock than I realized before participating in this thread.

Finally, I will pass on a technique that I have used several times to finance a start up company. Let me know if you see any problems with it—

A highly paid executive leaves his old company to form a new business. The new business forms a profit sharing plan that accepts rollovers and that is specifically allowed to invest up to 100 percent its assets in employer stock. The executive rolls over his substantial interest in his old plan into the new plan, and the new plan purchases stock in the new business. The executive thereby uses his retirement funds to capitalize a new start up company.

It gets better. If stock is distributed from the plan, I assume that it is valued for income tax purposes at FMV, taking into account lack of liquidation control, among other things, meaning that a 40 to 50 percent discount may be in order. Of course, the same benefits apply for estate and gift tax purposes too —icing on the cake. The stock, or its cash equivalent, that was distributed in the non LSD could be rolled over. (I can’t remember off hand whether cash equivalent can be rolled over without a sale first, but I think it can. I know for sure that other property of equivalent value cannot be rolled over.)

The NUA game is not available, however, unless or until a lump sum distribution takes place. If the LSD takes place after over half of the stock has been distributed, then a discount should be in order there as well, I presume. If cash is also distributed, I suppose one could use your 402©(6)© technique to help. I will have to study this.

[Guest Noel C Ice]

Am I correct in interpreting 402©(6)© as only helpful with respect to nondeductible employee contributions, and as inapplicable (other than perhaps indirectly) to NUA as such. And am I also correct in my understanding that in the case of employer securities attributable to employer contributions, that under all circumstances, the cost for deferring the NUA on distribution of the stock is recognition of ordinary income tax on the difference between FMV at date of distribution and the NUA, absent a rollover.

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Noel C. Ice

www.trustsandestates.net

teleice@Dtrustsandestates.net

[Guest c.s.]

Another question regarding the application of the NUA rules.....

A participant in a 401(k) plan terminated and rolled over his account balance, including employer stock, to a conduit IRA. He then was re-employed by the same company, so rolled his IRA account back into the same plan. Question: Will the employer stock that is rolled back into the plan retain its status as such, and if so, will NUA treatment be afforded the Participant when he takes a lump sum distribution of his account from the Plan?

I actually called the IRS on this and they replied that they did not have an answer and I should obtain a letter from the employee plans office. Not sure I want to go that route.

Thanks in advance for any insight.

[Guest]

My reaction is that it will definitely be considered employer securities but that its basis will be the FMV of the stock when it was rolled back into the plan from the IRA. In other words, you would not carryover the basis from the original distribution.

[Appleby]

Just in case someone finds this post- like I did when I searched via Google.

http://benefitslink.com/links/20021029-019131.html ...

[mbozek]

Another question regarding the application of the NUA rules.....

A participant in a 401(k) plan terminated and rolled over his account balance, including employer stock, to a conduit IRA. He then was re-employed by the same company, so rolled his IRA account back into the same plan. Question: Will the employer stock that is rolled back into the plan retain its status as such, and if so, will NUA treatment be afforded the Participant when he takes a lump sum distribution of his account from the Plan?

I actually called the IRS on this and they replied that they did not have an answer and I should obtain a letter from the employee plans office. Not sure I want to go that route.

Thanks in advance for any insight.

The House report to HR3 which was enacted as EGTRRA contains a statement on sections 641-3 of the bill that capital gains and income averaging treatment from a qualified plan distribution could be preserved if the distribution was rolled into a conduit IRA and then rolled back to another qualified plan. There may also be a PLR on this question.