NUA in LSD 401k
The 401-k Plan Administrator recognises the option of NUA in a LSD planned when the owner turns 70. However, the potential benefits of NUA would be limited to shares having cost basis equal to the after tax contributions or subject to withholding of tax on the cost basis in excess of the after tax contributions. In other words, pursuant to the administrator’s “rules”, the only shares that can be distributed for NUA benefit will be those for which taxes on the cost basis are fully paid. The administrator maintains detailed records of share cost bases to enable the determination of the tax liabilities for NUA share distribution.
The total account balance (FMV) is USD3.5 million, all in company shares. The account tax basis (i.e., cost of shares) is USD 1.1 million. I wonder if it might be possible to make the LSD of all shares into an after-tax (broker) account. The 1099R would show a gross distribution of USD 3.5 million and a taxable amount of USD 1.1 million. Within 60 days of the LSD, shares equivalent to the taxable amount would be rolled over into a traditional IRA, duly documented in Form 5498, so there would be no taxable amount. The remaining shares (equivalent to USD 2.4 million) would remain in the after-tax account as NUA shares and would be subject to capital gains tax when sold (presumably with a tax basis of zero…but I am not sure about this).
Does this approach for deferring all tax on a LSD while retaining the potential benefits of NUA have any precedent? Pitfalls? I have seen reference to this approach from other advisors (e.g., N. Choate, F. Duke).
Thanks, Nick
Permalink Submitted by Bruce Steiner on Wed, 2012-02-15 03:43
The authority is sparse. There’s an old private letter ruling that’s favorable that Frank Duke brought to my attention, another old private letter ruling that suggests it might not work, and a recent private letter ruling in which the taxpayer assumed it would work and didn’t ask for a ruling on that point.
Of course, before you reach this question, you have to conclude that NUA treatment is better than a rollover and possible Roth conversion.
Given the amount involved, you may wish to consult with tax/estates counsel on this.
Permalink Submitted by Alan Spross on Wed, 2012-02-15 23:54
I don’t think it is intended that the cost basis component and the NUA component for each share of stock can be detached from the individual share and reassigned such that the aggregate cost basis was rolled over and the aggregated NUA remained in the taxable account. It is taking some time to find a tax code reference to support this. If you have N Choate’s comments on this, please post them.
There have been other similar proposals that likely also would not pass IRS review:
1) Selling the shares and paying the LT cap gain rate and rolling over the proceeds
2) If the plan has basis from after tax contributions, allocating this entire basis to reduce the taxable NUA cost basis. This should be OK as long as it includes only the after tax amount allocated to the shares vrs the rest of the account rolled to an IRA.
3) Different lots of shares with different NUA %s. This should be OK if the plan accounts for different lots, but then the lower NUA shares should be sold in the plan before distribution. Once distributed, the cost basis will applied on an average cost basis, so you couldn’t identify the higher cost shares to roll them over to an IRA.
WIthin 60 days there is no doubt that the shares can be rolled to an IRA as a change of intent about using NUA. The wording in 402(e)(4) does leave some doubt about a partial rollover and using NUA for the other non rolled shares.
Will do some more digging.
Permalink Submitted by Nicholas Ciani on Thu, 2012-02-16 03:34
Following are extracts from the NUA sections of N. Choate’s “Life and Death Planning for Retirement…” that are petinent to the LSD/NUA strategy:
1. “…Rolling over everything except the NUA stock: If the employee receives a distribution that (i) meets the LSD requirements (¶ 2.4.02–¶ 2.4.05) and (ii) includes employer securities, the employee can exclude from his income the NUA inherent in the securities, while rolling over to an IRA the rest of the distribution, i.e., the assets other than the employer securities, which otherwise would be included in gross income. See PLRs 2004-10023, 2001-38030,2001-38031, 2000-38052, 2000-38057, 9721036. This can even be done by direct rollover of the nonstock assets to another plan; see PLR 2000-03058”.
2. “…Rolling over part of the NUA stock: If the employee rolls over some but not all of the employer stock, the NUA and employer basis must be allocated, somehow, between the rolled and the nonrolled stock. The employee would like to allocate the NUA, to the maximum extent possible, to the stock that is not rolled over, so as to: postpone taxes on that portion until the stock is sold; incur tax on that portion only at capital gain rates; and (if he is under age 59½ and does not qualify for any exception to the premature distributions penalty), avoid the 10 percent penalty (¶ 9.1.03(A)).
The employee would like to allocate the ordinary-income employer-basis portion of the distribution, to the maximum extent possible, to the stock that is rolled over to the IRA, so he does not have to pay current tax on it.
Would that method of allocation be correct? Yes, according to the IRS in the well-reasoned PLR 8538062, which is the only IRS pronouncement discussing this subject. Though there is no authority directly on point, this approach is consistent with other regulations on similar subjects…”.
Ms. Choate also refers in her book to to tax advisors that have arranged for the described NUA strategy for many clients with no IRS objection.
The strategy is, after all, not avoiding ordinary income tax on the NUA share basis, but deferring such tax until the basis is withdrawn from the IRA.
Thanks for sharing knowledge and experience.
Permalink Submitted by Alan Spross on Thu, 2012-02-16 21:01
Located this, copied from the Joint Committee on Employee Benefits Findings, back in 2000:
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17. §402 – Taxability of Beneficiary of Employees’ Trust
Is PLR 8538062 (June 25, 1985) still good law? Under this PLR, to the extent that
the participant rolls over a portion of the distribution, the taxable portion of the
distribution is reduced by the fair market value of the stock rolled over. Thus, the
participant can retain shares equal to the NUA and rollover an amount of stock
equal to the basis. There would be no tax on distribution, and the participant
would get long-term capital gain treatment when the retained portion of the stock
is sold.
Proposed Answer: No. That PLR was issued in error.
IRS Answer: The IRS agrees with the proposed answer. Net unrealized
appreciation follows the stock. If the stock is rolled over to an IRA, the ability to
use the net unrealized appreciation rules on the stock is lost. The net unrealized
appreciation treatment follows the stock.
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This makes more sense to me. If both basis and the NUA are allocated to each share of stock, this strategy would not work. And if the NUA follows the stock, so would the cost basis. But I still want to test this out with appropriate sections of the current tax code.
Permalink Submitted by Bruce Steiner on Thu, 2012-02-16 21:19
I’ve discussed this with the individuals previously mentioned, and others, but it’s not appropriate to post someone’s private comments in a public forum.
PLR 8538062 says you can roll over shares having a value equal to the toal cost of the shares.
PLR 201144040 assumed you can do this. The taxpayer did not ask for a ruling on this issue, since he assumed that he could do this. He was not not aware of PLR 8538062.
PLR 8426132 assumed you couldn’t do this.
I don’t think you can give much weight to a case where an IRS agent didn’t spot the issue, or spotted the issue and didn’t pursue it.
There’s no way any of us can be sure whether you can or cannot do this. Read the rulings and whatever else you think appropriate, and draw your own conclusion. Consider applying for your own ruling. Also consider whether NUA is preferable to rolling all of the shares over into an IRA and getting rollover and a possible Roth conversion, but giving up capital gains treatment for the NUA.
Permalink Submitted by Alan Spross on Thu, 2012-02-16 23:04
Taxpayers may have done this with the IRS not understanding the underlying cost basis or how the partial rollover was being used to throw the basis into the rollover while accumulating NUA in the remaining shares. We already know that the IRS misses may IRA related infractions that are far more common than NUA issues. One factor that may bring this to a head is the broker basis reporting responsibilities when reporting stock sales.
If the LSD were processed now, the broker would have to first collect knowledge of the traditional NUA cost basis per share. When the taxpayer eventually sells those shares, the broker will need to report the basis to the taxpayer and the IRS on Form 1099 B. Of course, the taxpayer could still endeavor to Use Form 8949 to override the reported cost basis, but that in itself could throw up a red flag to the IRS.
This letter ruling may be applicable to this issue, and appears to support the strategy. ie aggregating the cost basis into the rollover:
http://www.legalbitstream.com/scripts/isyswebext.dll?op=get&uri=/isysque…
As Bruce indicates, doing this without your own letter ruling is rolling the dice.
Permalink Submitted by Nicholas Ciani on Fri, 2012-02-17 19:44
Under the hypothetical scenario under discussion, how would it be reported to the tax authorities and properly documented?
Presumably a 1099R would be issued by the 401-k Plan covering the LSD directly to the distributee. The 1099R would show a gross distribution of USD 3.5 million (line 1) and a taxable amount of USD 1.1 million (line 2a). On the 1040 Tax Form, line 15a would show the gross distribution. The words “Rollover/NUA?” would be entered next to line 15b. And zero would be entered in line 15b (i.e., zero gross income included in current year tax calculation). Perhaps an explanation statement would need to be included to show that the taxable amount in kind was rolled over to an IRA and the balance was retained as NUA. Would this make sense?
The total employee shares distributed as LSD by the 401-k Plan would be deposited in a separate after-tax account set up for this purpose. The indirect rollover of shares equivalent to the taxable amount (or more depending on the taxpayer’s individual plans for tax and estate management) would be transferred within 60 days from this after-tax account. The rollover would be documented for tax purposes when the new IRA custodian issues the corresponding 5498.
The shares remaining in the after-tax account would constitute the NUA shares with cost basis of zero, such that the gross proceeds from any future stock sale would be taxed at the capital gains rate. Different rules would apply if these NUA shares are inherited after taxpayer death.
Might the foregoing approach work?
Thanks for the discussion of this strategy.
Permalink Submitted by Alan Spross on Fri, 2012-02-17 21:48
I just rechecked your original post, and it appears that there might be after tax contributions in this plan. If so, the PLAN ITSELF has basis and this basis is totally different than the cost basis for NUA purposes. In addition, in order to ulitize NUA, there must be a qualified LSD, ie a total distribution of all plan and similar plan balances of that employer. Further, there should be NO intervening distributions from the plan in a year prior to the LSD year and after the last triggering event. Triggering events are separation from service, reaching 59.5, death or disability. Therefore, if he has just recently separated from service and did not take out another distribution in the meantime, he should be OK for LSD. The final issue relates to RMDs. Since the year he reaches 70.5 will be an RMD year if he separates from service, the RMD will have to be satisfied, but the NUA itself would more than satisfy the RMD. It is a distribution from the plan and will not be rolled over.
The 1099R would show 3.5m in Box 1, 1.1m in Box 2a and 2.4m in Box 6. Dist Code in Box 7 would be 7 (Normal). If after tax contributions were made to the plan, Box 2a will be reduced by the amount of those after tax contributions and the amount of that reduction would go in Box 5. The NUA would not change and all the boxes other than 1 would add up to the Box 1 amount. Box 2b (Total Distribution) would be checked reflecting the LSD. Since there is no federal withholding required on distributions of employer securities, Box 4 should be empty. All of this should be reviewed with the employer before ordering the distribution, because the IRS will be matching the return to the 1099R. Any withholding would have to be done by sale of shares and it would mess things up real bad if someone automatically began to liquidate shares for withholding which does NOT apply.
The above 1099R would result in 3.5mm on line 16a of Form 1040, with nothing on 16b and “rollover” entered next to 16b (not 15b). The IRS will see from the 1099R that a large amount of NUA was distributed, but I don’t think extra attention should be initiated by an explanatory statement. Since the rollover of shares is allowed, that is not a problem, but bringing the allocation issues of the cost basis and NUA to IRS attention may not be beneficial. The taxpayer would hope that the 5498 issued by the IRA custodian in the amount of the cost basis will clear out the problem, but an explanatory statement indicating that the entire rollover consisted of cost basis might stimulate more questions and invite problems. If the IRS balks at -0- taxable income on 16a there will be plenty of opportunity to explain this at the time.
With respect to the shares in the taxable account, the -0- cost basis resulting from them being characterized as 100% NUA presents the second challenge when the first of those shares are sold. This is where the broker holding that account comes into play with the new cost basis reporting provisions that now apply with respect to stock shares. If the broker assigns -0- basis, when the first shares are sold and reported on Form 8949 and Sch D, it presents another chance for the IRS to look into the matter, even though they are getting a LT cap gain tax on the entire amount. If the broker does not understand all of this and assigns some basis, the taxpayer has another decision to make. If he accepts any basis, he is indirectly saying that the rollover included some NUA because because some of his taxable account was reported as basis.
You are correct when the taxpayer passes, the shares arguably being composed of NUA do not get a basis adjustment because NUA is IRD. Any gains in addition to the NUA would be subject to basis adjustment for the beneficiaries. Any losses just reduce the amount of NUA.
I assume diversification would be attempted by selling the shares that went into the IRA, but he would still have a far too large holding in one stock. He also will be concerned with where LT cap gain rates go after this year.
FInal Note: The last paragraph of the following code section appears to be the key portion of the code on which he is depending. It is 402(c)2 which states the the taxable portion of a distribution is deemed to be the first dollars rolled over to the IRA:
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(2) Maximum amount which may be rolled over
In the case of any eligible rollover distribution, the maximum amount transferred to which paragraph (1) applies shall not exceed the portion of such distribution which is includible in gross income (determined without regard to paragraph (1)). The preceding sentence shall not apply to such distribution to the extent—
(A) such portion is transferred in a direct trustee-to-trustee transfer to a qualified trust or to an annuity contract described in section 403 (b) and such trust or contract provides for separate accounting for amounts so transferred (and earnings thereon), including separately accounting for the portion of such distribution which is includible in gross income and the portion of such distribution which is not so includible, or
(B) such portion is transferred to an eligible retirement plan described in clause (i) or (ii) of paragraph (8)(B).
In the case of a transfer described in subparagraph (A) or (B), the amount transferred shall be treated as consisting first of the portion of such distribution that is includible in gross income (determined without regard to paragraph (1)).
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Permalink Submitted by Nicholas Ciani on Sat, 2012-02-18 14:27
Thank you for the clear and concise description of how this hypothetical transaction might be reported.
In this particular case, the LSD is ok since the 401-k owner is older than 59 1/2 and there have been no previous distributions made from the account. The 401-k assets are largely, if not completely, held as employer shares purchased within the Plan with employee contributions (before and after tax), employer matches, and dividend reinvestments.
It is correct that the 401-k contains after-tax contributions of around USD 66 k, which would not be reported as a taxable amount (line 2a in 1099R) and, presumably, would not be included in the indirect rollover shares (assuming that the rollover is limited to only the taxable amount). This would mean that the NUA shares not rolled over would have a basis equal to the after tax contributions.
There is sufficient accounting of cost basis for the shares held in the 401-k to assign the after-tax contributions to selected NUA shares, leaving the remainder of the NUA shares with zero cost basis. But this discretionary handling of basis might be sloppy to report and unacceptable.
Two alternatives come to mind: 1) do two distributions within a tax year: the first would take the NUA shares having a basis equal to the after-tax contributions (having the Plan rather than the taxpayer do the administrative handling and documentation). The second distribution would be a LSD of the remainder of the shares (with the tax basis equivalent rolled over and the remainder held in a separate after tax account with zero basis); 2) do a single LSD and include the after tax contributions in the rollover shares amount and deal with it as a last-in component (all non-rollover NUA shares would be held at zero basis).
In any event, the LSD distribution strategy under consideration is NOT aimed at avoiding taxes, but maximizing the preferred NUA treatment and deferring applicable taxes to the extent that regulation allows (which is, as everyone points out, a grey area at best). On an undiscounted basis, the IRS would be kept whole regardless..so long as transparent records are maintained. But this opinion may be a self-serving oversimplification and/or plain wrong.