Employees distributing their employer's stock from a retirement plan may be able to take advantage of a special tax treatment called net unrealized appreciation.
Clients retiring from large public companies may have significant amounts of their employer's stock as an asset in their retirement plans. For long-term employees, this stock may have enjoyed significant appreciation from the date of contribution. Provided the employer's retirement plan is a qualified plan under §401(a), such as pension, profit-sharing, 401(k), or stock-bonus plans, and the client takes a lump-sum distribution of the full balance due, the net unrealized appreciation distribution strategy may be appropriate.
This special tax treatment allows for capital gains treatment of any embedded appreciation, rather than having it taxed as ordinary income. If a few basic requirements are met, your client would be able to distribute the shares of stock in-kind from the retirement plan to a taxable brokerage account and pay ordinary income taxes on the stock's original tax basis. The tax basis is the value of the shares when they are deposited into the plan. This basis would be taxed at the client's marginal income rate in the year of distribution. The embedded appreciation in those shares (the fair market value as of the date of distribution less the tax basis), however, would be considered long-term capital gains. The gain from this approach would not be taxed until the shares are sold, which could be as soon as the day after distribution.
Most large public companies (and some large privately held companies) that allow contributions of their own stock to their retirement plans do track the original basis by share, or at least by an average cost per share, so the basis can be determined.
Any gains or losses that accrue to the shares post-distribution will follow the normal capital gain/loss rules. Gains or losses realized within 12 months of the distribution date (other than the gains embedded in the shares upon distribution) will be treated as short-term gains or losses.
A key requirement here is that the distribution must be considered a lump-sum distribution. All balances to the credit of the participant from all like plans of the same employer must be distributed in the same calendar year. This means, for instance, that if the employer has two different profit-sharing plans, the full balance of both plans must be distributed in the same year.
Note that many employer plans fund the prior year's contribution as late as October the following year. If the employee takes a partial or full distribution before this final funding, he or she will not have taken the full credit due and thus invalidate the lump-sum nature of the distribution. You must work closely with your client's plan services department to verify that no additional funds will accrue to your client before a lump-sum distribution is taken.
Here's an example of how the NUA treatment works:
Your client has 2,500 shares of his employer's stock currently worth $100 per share in his 401(k) plan. The employer determines that the original basis of the stock, whether tracked by specific shares or average cost per share, is $15 per share. The client's stock is worth $250,000 with a tax basis of $37,500. (These figures actually aren't all that unusual for employees who have spent 20 years or more with the same company or its predecessors.)