Allowing employees to enjoy the success of a company can be a helpful motivator and reward. Employer-sponsored retirement plans that allow employees to purchase company stock enable employees to gain a stake in the company, which can also present them with Net Unrealized Appreciation (NUA) opportunities. In most cases, distributions made from tax-preferenced retirement accounts are taxed at ordinary income rates. However, when stock held in an employer plan is eligible for NUA treatment, participants pay ordinary income tax only on the cumulative purchase price of the shares upon distribution, and can enjoy long-term capital gains taxes on the growth of those shares (assuming certain NUA requirements are met).
Advisors with clients who can benefit from NUA opportunities must ensure that three rules are met. First, the distribution must be completed after the participant experiences a “Triggering Event”, which are attainment of age 59 1/2, separation from service (whether voluntary or not), or death. Second, the distribution must be made as a “Lump-Sum Distribution”, which means that assets must be completely distributed within one calendar year. Lastly, the employer stock shares must be distributed from the employer-sponsored retirement plan “in-kind” (i.e., maintained as employer stock shares and not liquidated) into a taxable account. These three rules are non-negotiable, and violating any of them removes any possibility of using the NUA tax break.
Additionally, unlike employees in publicly traded companies, those who work for privately traded companies can be faced with limitations on how their employer stock shares must be distributed (particularly from an ESOP). Because there is no law that requires employers to make this option available to plan participants, some employers may incorporate ESOP prohibitions that make true “in-kind” distributions impossible (in order to limit outside investors from owning the closely held stock). In other cases, the privately held stock may be transferrable, but there are restrictions on holding the stock outside the ESOP which may make NUA transactions complicated to fully realize – or at least not worthwhile.
Which means that advisors can help clients who are employees of private companies determine whether they can take advantage of NUA in the first place. For example, employees who work for S corporations may have distribution contingencies in their plan that result in an immediate long-term capital gain tax on distributions that need to be immediately sold, on top of the ordinary income tax due on the original purchase price.
Ultimately, for participants in these instances, knowledge is power – both pertaining to navigating the requirements to take advantage of NUA tax benefits when they are available, and selecting the best alternative options (such as rollovers into other retirement accounts) if the NUA strategy ends out to be tax-inefficient!