How do you apply the 10% early distribution penalty to distribution of Employer stock?

[k man]

the employee is terminating before 59 1/2 and will receive a lump sum distribution. with respect to lump sum distributions of employer stock, the code says that the employee is not taxed on the NUA. in that case do they have to pay the 10% penalty and if so would it only be on the basis portion of the distribution?

[mbozek]

Tax is imposed only on portion of distribution that is taxed as ordinary income, i.e., employer basis, since employee only pays LTCG on stock in year when it is sold.

[Guest Harry O]

Unless, for some reason, the employee elects to waive the NUA exclusion.

[mbozek]

Why would anybody elect to be taxed at ordinary income tax rates instead of 15% (5% for taxpayers in the 10-15% bracket) and pay an additional 10% penalty.?

[JDuns]

Most employees do not elect to receive the portion of their account invested in employer stock in kind (which is one of the conditions to avoid the tax on the appreciation). In addition, if they roll over the entire account balance to an IRA, they ruin the special rule.

There are situations where either of these choices make sense (but I agree that paying the higher ordinary income tax rate plus 10% is a high hurdle to pass).

[Guest Harry O]

If you were eligible for 10-year averaging there are cases where waiving NUA can result in lower taxes (of course anyone still eligible for 10-year averaging isn't likely to face a 10% early distribution penalty).

[Kirk Maldonado]

mbozek:

You said:

Tax is imposed only on portion of distribution that is taxed as ordinary income, i.e., employer basis * * *.

I assume that you meant the employe's basis. Obviously, the employer doesn't have any basis in its own stock.

Your post showed that you are aware of a nuance that is unknown to many people; the employee's basis in the shares is not necessarily the same as the plan's "basis" in those shares.

[Guest quinn the car fixer]

is he/she 55 when they term?

[Kirk Maldonado]

Mbozek:

You asked:

Why would anybody elect to be taxed at ordinary income tax rates instead of 15% (5% for taxpayers in the 10-15% bracket) and pay an additional 10% penalty?

My recollection is that there is a discussion of this point in the BNA Tax Management Portfolio on distributions.

One reason, which may or may not be listed in the portfolio, is that the person might have some expiring tax losses that could be used to shelter the income relating to the distribution.

Interestingly enough, I am working on a coporate transaction right now where both parties are very motivated to get the deal done soon because of some expiring tax losses.

[mbozek]

Kirk:

I am not sure what tax losses could be deducted against ordinary income by an individual. Capital losses are limited to $3,000. The only losses that an indivdual can take against ordinary income are casualty losses and losses from a trade or business. Losses from passive activities such as tax shelters can only be deducted from gains on passive activities. None of these losses can be deducted against the tax on 10 year averaging which is an initial separate tax on the taxable distribution and is added to any other income tax due. The only logical reason for electing to treat the NUA as ordinry income is if a 69 yr old eligible for a lump sum would be able to avoid the 10 yr averaging tax under the de minimus exclusion for small distributions, since 1986 tax rates are used to determine the tax using the table for a single individual with no exemptions or deductions.

I used the term employer basis because ordinary income tax on pre tax contributions is determined by the fmv of the employer's cost basis of the stock at the time the stock was contributed to the plan by the employer. The employee's basis for NUA refers to the FMV of stock purchased with after tax contributions made by the employee. An employee can elect to treat gain on stock purchased with after tax contributions as NUA without the need to receive a lump sum distribution from the plan which would result in no ordinary income subject to taxation in the year such stock is distributed.

[Kirk Maldonado]

mbozek:

I can tell you from personal experience that there are some defunct law firms that had huge losses from that trade or business that passed through to partners, in order of magnitude of hundreds of thousands of a dollars for a single year.

[Kirk Maldonado]

mbozek:

Here are the factors that were listed in BNA Tax Management Portfolio #370 that I mentioned in an earlier post:

In choosing whether to elect current includibility, i.e., a waiver of NUA treatment, the factors to be considered are: (1) whether the existing capital gains rate is lower than that applicable to ordinary income; (2) the possibility that the tax rates applicable to ordinary income may be increased; (3) the applicability of the §72(t) additional 10% tax on early withdrawals if the NUA is treated as part of and includible in gross income for the year of distribution; (4) whether, in the case of a waiver election, a portion of the distributed employer securities must be sold to pay the tax due; and (5) whether current taxability of the NUA will provide less capital upon which an investment return can be obtained.

[mbozek]

I dont think large losses from trade or business losses are likely for corporate employees who recieve a distribution of employer stock

The factors you cite dont do much to change evaluaton of the choice. 1,2 and 3 make CG the better choice since the taxes will be less or non existant. 4 favors CG. 5 is only factor that favors electing to waive NUA if the distribution would be exempt from income tax under 10 yr averaging.

[Kirk Maldonado]

mbozek:

If I gave people the impression that I was endorsing the items on that list as being valid, that was an error; I should have stated that I wasn't commenting one way or the other on whether those items had any practical application.

To belatedly clarify the matter, I was just providing a list that others had accumulated without any editorial comment from me, so that others could draw their own conclusion.

I agree that the likelihood of someone having large losses that could be offset against the appreciation in the employer stock is very unlikely. I was just pointing out that there are cases where individuals have losses that they can use to offset ordinary income.