The special treatment for net unrealized appreciation (NUA) is a great tool for clients who have appreciated employer stock in their 401(k), ESOP or other employer plan.
Essentially, NUA treatment is one of many tax incentives that were enacted to encourage employee ownership. For employees who have been fortunate enough to see their stock increase in value, and who receive proper advice from their advisors, NUA treatment can offer the opportunity to treat that gain as capital gain instead of ordinary income.
However, the NUA rules are complex and must be followed carefully. In a recent ruling, the Internal Revenue Service declined to allow a waiver of the 60-day rollover deadline as a remedy for failure to follow those rules.
There are two critical elements to obtaining NUA treatment: (1) a lump sum distribution from the plan, as defined below, and (2) a taxable distribution (not a rollover) of the eligible securities.
For NUA treatment to be available, the participant generally must receive the securities in a lump sum distribution. A lump sum distribution is defined as a distribution of the balance to the credit of the employee (all amounts in the account) within one year, that is made: (i) on account of the employee’s death, (ii) after the employee attained age 59 1/2, or (iii) on account of the employee’s separation from service. If the distribution does not satisfy this definition, it generally will not qualify for NUA treatment, as was the case in the recent IRS ruling.
Some advisors consider it safe to recommend routinely that all qualified plan distributions be rolled over to an IRA at retirement. This advice will destroy any opportunity for NUA treatment. If a distribution that includes employer securities is rolled over (even as an in-kind distribution), gain on the securities will be subject to ordinary income treatment. With respect to the qualifying securities, the distribution must be received on a taxable basis to be eligible for NUA treatment.
The customer in the recent ruling had an advisor who knew enough to tell him not to roll over his employer securities. So, he took a taxable distribution of the securities. But as it turned out, the customer’s payouts from his employer plans had been made over more than one year; thus, they did not qualify as a lump sum distribution. Consequently, NUA treatment was not available, and the gain on the securities was fully taxable as ordinary income.
In the letter ruling, the taxpayer asked the IRS to grant a waiver of the 60-day rollover deadline and requested permission to change retroactively the transaction to a rollover instead of a taxable distribution. The IRS denied the request, stating the waiver was designed for instances where the taxpayer intended to make a rollover but failed through an institution’s error or advisor’s mistaken advice. Here, the taxpayer did not intend to roll over the distribution. The lesson from the IRS was that the 60-day waiver is not a remedy for misunderstandings of the law. (This ruling is Let. Rul. 200617039.)