Probate & Trust Law Section Conference Manual ... - Minnesota CLE

The Well-Prepared Executive: Personal Wealth Preservation Strategies
IRA, the presence of company stock in the 401(k)
account raises planning issues. As discussed below,
an in-kind distribution of company stock from the
qualified plan qualifies for special tax treatment of
the net unrealized appreciation in the company
stock.
B. Definition of Net Unrealized
Appreciation
Net unrealized appreciation is the difference
between the fair market value of the company stock
at the time of distribution of the stock from the
qualified plan and the cost or other basis of the
company stock within the plan. For example, if the
executive bought company stock within the 401(k)
account for $10 per share and the stock is now
worth $25, the net unrealized appreciation is $15 per
share.
C. Tax Treatment of In-Kind Distribution of
Company Stock from Qualified Plan
If the executive takes an in-kind distribution
of company stock from the qualified plan, the
executive will recognize ordinary income at the time
of distribution on the cost basis of the shares (i.e. the
$10 in the example above), but will not recognize
ordinary income on the net unrealized appreciation
(i.e. the $15 in the example above) at the time of
distribution. If the distribution is part of a lump sum
distribution, then there also is no recognition of
income for net unrealized appreciation on company
stock attributable to employer contributions to the
plan. If the distribution is not part of a lump sum
distribution then the special tax treatment applies
only to company stock attributable to the
employee’s contributions to the plan.
1. The executive can opt-out of this special tax
treatment if he is receiving a lump sum distribution.
That is, the executive can chose to recognize
ordinary income on the full value of the in-kind
distribution of company stock.
2. The net unrealized appreciation is taxable as
long term capital gain once the gain is realized in a
subsequent disposition of the company stock. This
is true even if the company stock is sold less than
one year after it is distributed out of the qualified
plan.
3. Realized gain in excess of the net unrealized
appreciation is taxable either as short term or long
term gain, depending on whether the one-year long
term capital gain holding period is met. The holding
period begins on the date of distribution of the
company stock from the qualified plan.
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4. If the executive dies still owning the
company stock that was distributed from the
qualified plan, then the capital gains tax will still be
owed by the beneficiaries on the net unrealized
appreciation at the time the beneficiaries sell the
shares. There is no step-up in basis on the net
unrealized appreciation. Any further increase in
value above the net unrealized appreciation qualifies
for a step-up in basis.
5. Beware the 10% early distribution penalty,
though. A 10% early distribution penalty applies to
distributions from an employer’s qualified plan
taken before age 59 ½. This penalty is applicable to
in-kind distributions of company stock. If the
penalty applies it substantially reduces the possible
tax benefits from taking an in-kind distribution of
company stock.
D. Comparison to Roll-over to IRA
If the executive decides not to take an inkind
distribution of the company stock, and instead
rolls the company stock out of the qualified plan
into an IRA, then the executive avoids any current
taxation. However, the entire amount would be
taxed as ordinary income when distributed from the
IRA – whether the distribution is to the executive, or
to the beneficiary of the IRA after the executive’s
death.
E. Partial Distribution is Permitted
An executive can decide to take some
company stock out as an in-kind distribution, and
can roll-over the rest to an IRA.
F. Who Should Consider an In-Kind
Distribution of Company Stock From a Qualified
Plan
1. those with highly appreciated company
stock in the qualified plan
2. those in the top income tax bracket, where
the spread between the 20% long term capital gains
rate and the 39.6% top marginal ordinary income
tax rate is greatest
3. those who can afford to pay the current
income tax that will be owed on the basis of the
company stock that is distributed from the qualified
plan
4. those who otherwise have a diversified
portfolio – an executive who wants to diversify out
of the company stock may prefer to do that inside a
401(k) or an IRA to defer any taxation