The general rule that plan distributions are includable in taxable income in the year received does not apply to distributions of the net unrealized appreciation in employer securities. What is Net Unrealized Appreciation (NUA)?
Rev. 03/23/06, E-mail Alert 2006-6

Employer Stock or Securities Distributed from the Plan in a Lump Sum Distribution

There is a special rule for a payment from the plan that includes employer stock (or other employer securities). To use this special rule:

1. the payment must qualify as a lump sum distribution (defined below); except that you do not need five years of plan participation, or
2. the employer stock included in the payment must be attributable to “after-tax” employee contributions, if any.

If either of the above requirements is satisfied, you will have the option of not paying taxes on the “net unrealized appreciation” of the stock until you actually sell the securities.

What is Net Unrealized Appreciation?
Generally, net unrealized appreciation is the increase in the value of the employer stock while it was held by the plan. For example, if employer stock were contributed to or acquired by your plan account when it was worth $1,000 and the stock has increased in value to $1,800 when it was actually received by you, you would not have to pay tax on the $800 increase in value until you later sold the stock, if either of the above requirements is met. Additionally, at the time of the sale, you may qualify for a lower “capital gains” tax rate, rather than being taxed at ordinary rates.

Alternatively, you may instead elect not to apply the special rule. In that case, the net unrealized appreciation will be taxed as ordinary income in the year you receive the stock from the qualified plan.

Rollover Rules
Stock may be rolled directly to another qualified plan. In that case, the eligibility for special tax treatment may be preserved if a lump sum distribution is taken when the participant ultimately terminates employment.

Stock may also be rolled over to a traditional IRA. However, if that occurs, the net unrealized appreciation is taxable upon the employer securities being distributed from the IRA.

Eligible Rollover Distribution Withholding Rules
If you receive a distribution that is limited to employer stock only, and that distribution is eligible for rollover, no cash amount is required to be withheld from the distribution under the 20% mandatory withholding rules. If you receive an eligible rollover distribution that includes cash or property other than employer stock in addition to employer stock, the 20% withholding amount is based on the entire taxable amount paid to you (including the value of the employer stock determined by excluding the net unrealized appreciation). However, the maximum amount withheld will be limited to the value of the cash or property other than employer stock.

10-Year Averaging if Born Prior to 1936
If you receive employer stock in a payment that qualifies as a lump sum distribution, the special tax treatment for lump sum distributions described above (such as 10-year averaging) also may apply. See IRS Form 4972 for additional information on these rules.

What is a lump sum distribution?
For the purposes of the NUA special rule, a lump sum distribution is a payment, within one year, of your entire balance under the plan (and certain other similar plans of the Employer) that is payable to you after you have reached age 59½ or because you have separated from service with your Employer (or, in the case of a self-employed individual, after you have reached age 59½ or have become disabled). There was also a five-year participation requirement to be eligible for lump sum treatment.

In the early 1980s and before, the definition of a lump sum distribution was significant for a number of special tax treatment reasons. Most of those reasons no longer exist in the Code. For example, there was a requirement that only lump sum distributions were eligible to be rolled over into an IRA. Though still existing as a grandfathered rule for those who were born prior to 1936, another example of a former use of the lump sum distribution requirement was for the 10-year income averaging method of paying taxes on the entire distribution.

What happens If the Participant chooses to defer taxation of the NUA and dies before selling the stock?
Generally, the beneficiaries would pay tax on the NUA when the stock is sold.

Bill Grossman, QPA