How is participant taxed when shares sold to employer per mandatory "put" option?

[Gruegen]

A company's bylaws provide that shares of the employer may not be held outside the ESOP. As such, the ESOP document indicates that terminated participants are required to put their shares back to the employer.

Question: What is the tax implication to the participant of the "put option?" Which of the following scenarios are anything resembling correct? Can a plan provide for either scenario? Any help would be greatly appreciated.

1) John Smith holds 100 shares (market value $10/sh; cost basis of $3/sh) of ABC Company in his ESOP plan account. The ESOP distributes the 100 shares to him as a "distribution" - - as such, he is subject to income tax on the $300 (lower of cost or market) and the trustee of the Plan prepares a Form 1099-R reflecting a $300 distribution with $700 of NUA. He immediately sells the shares to the employer and receives the $1,000 cash. He now has a taxable capital gain of $700. The $1,000 cash he received from the employer cannot be rolled over.

2) Kathy Smith holds 100 shares (market value $10/sh; cost basis of $3/sh) of ABC Company in her ESOP plan account. Before a distribution is made to her, the ESOP buys the 100 shares from her and replaces it with $1,000 cash. The participant is then provided an opportunity to elect what to do with the $1,000 of cash in his ESOP account - - rollover to IRA, rollover to QP or distribute to participant. To the extent that it is paid to the participant, there is no NUA and the participant is subject to income tax on the full $1,000.

[RLL]

Hi Gruegen ---

1) You are correct except for your last sentence. The $1,000 cash proceeds received from the employer can be rolled over by John, per IRC section 402©(6). To the extent rolled over, there is no current taxation.

2) You are correct. I assume you mean that the ESOP exchanges the shares in Kathy's account for cash (within the ESOP) prior to the distribution.

[mbozek]

While I agree with RLLs analysis there is a question as to whether a participant should rollover the $700 capital gain when it is subject to a maximum federal tax of 15% ($105). Rolling it over to an IRA will result in not only the $700 but any earnings being subject to marginal income tax rates which could be more than 15% at distribution.

[Kirk Maldonado]

What is the authority that says that the person is only taxed on the fair market value of the stock when it is distributed, if that amount is less than the basis in the stock?

While that result certainly has a logical appeal, it seems to fly in the face of the rules regarding the tax treatment of NUA.

[RLL]

Hi Kirk ---

The general rule of taxation (of qualified plan benefit distributions) is IRC section 402(a), under which distributed property is taxed at its fair market value. See Reg. section 1.402(a)-1(a)(1)(iii).

Section 402(e)(4) provides for the exclusion of NUA in the case of certain distributions of employer stock, but the IRC does not address circumstances involving net unrealized depreciation ("NUD"). See Reg. section 1.402(a)-1(b).

There is no provision in section 402 (or in section 72) which would impose tax on the cost basis of distributed employer stock to the extent that it exceeds fair market value.

** By the way, how do you like being "mile high" ?

[Kirk Maldonado]

Hi RLL:

Thanks for your input. As I indicated above, I liked the result, but I wasn't aware of any specific authority. You confirmed that you get to that result by reasoning, rather than by a specific statutory or regulatory authority.

I really like Denver. California has it great points, but so does Colorado. They are both equally enjoyable places to live, but for very different reasons.

[Gruegen]

Thanks for all of your responses. I have two more questions pursuant to Scenario #1:

1) Assuming the participant puts the shares back to the company and elects to rollover the proceeds pursuant to IRC 402©(6), how is the Form 1099-R for the distribution from the Plan prepared?

2) Assuming the participant puts the shares back to the company and elects to rollover the proceeds pursuant to IRC 402©(6), does the participant have any NUA in the $1,000? In other words, is there a need for the plan to supply the participant with NUA information if they roll over the proceeds?

[BeckyMiller]

The filing instructions to Form 1099-R are actually quite helpful on this point. The forms are generally completed as if the Plan Administrator had no idea what the participant actually did once the distribution was made.

So, if shares are distributed in an event that is eligible for rollover, but was not a direct rollover, the Form 1099-R should show gross distribution(current value), taxable amount, NUA and the appropriate code in Box 7. If cash is distributed, there is no need to report the NUA.

If you look at the instructions, you will note that there is not a code for an eligible rollover distribution. If it is an early distribution, Code 1 is generally used and the recipient is provided with guidance on how to report an indirect rollover on his or her return. Code 2 is used if there is a known exception to the premature distribution penalty. If it is not an "early distribution", then Code 6 would apply as a Normal Distribution.

On this point, the instructions describing NUA are not particularly helpful. They talk about taxation, but do not describe the right to rollover and avoid tax. That is why each participant eligible for a distribution is to receive the standard tax notice.