IRS clarifies tax treatment of ESOP distributions

The IRS has issued guidance to companies making distributions from an Employee Stock Ownership Plan (ESOP) to participants who have been terminated from the plan.

Some ESOP companies allow, or even require, terminated plan participants who receive distributions of company stock to sell that stock back to the company. The IRS Technical Advice Memorandum, or TAM, is important for all ESOP companies in that situation, said the law firm of Morgan, Lewis & Brockius LLP in a newsletter last week.

The TAM stemmed from a case involving a question over the appropriate tax treatment of distributions of employer stock to a group of terminated employees, who decided to sell their shares back to the company immediately upon distribution of their benefits. The local IRS office contended that the terminated participants were, in effect, receiving their benefits in cash, and so the company was liable for penalties for failing to withhold taxes.

The IRS national office determined that stock distributions from the company's ESOP to the participants should not be treated as cash distributions when the participants immediately sold their shares back to the company. The local office also denied some claims for capital gains treatment when it came to net unrealized appreciation on the shares credited to their accounts.

The national office rejected the position of the local office. "If the national office had upheld the position taken by the local office, ESOP companies that allowed for ESOP benefits to be paid in the form of company stock would be required to issue share certificates to the participants even in situations where the participants elect or are required to immediately sell the stock back to the company," the LawFlash newsletter said. "This would create a significant administrative burden for companies with large numbers of employees."

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