The Importance of Tracking Cost Basis in your ESOP
In my previous blog post regarding Net Unrealized Appreciation (NUA) tax benefits for ESOP participants, I mentioned the cost basis of stock distributions is taxed at the individual’s ordinary income tax rate. In order to accurately determine the NUA on a stock distribution, the cost basis has to be tracked as part of the plan administration process.
Determining the Cost Basis
The original cost basis of an employer security in an ESOP is the value of the stock when it was deposited into the ESOP trust. While that computation is pretty straightforward, keeping the cost basis allocation accurate on a participant level can get complicated quickly. This is especially true if there are multiple stock transactions that have occurred during the life of the ESOP and the shares have not been tracked in separate accounts by transaction.
Treas. Reg. §1.402(a)-1(b)(2) sites four methods that can be used in computing the cost basis of the employers securities in the ESOP:
- Earmarking Method
- 12-Month Allocation Method
- Single Security Type Method
- Average Cost Method
Private Letter Ruling 9147053 provides supplemental guidance on determining cost basis for a number of possible ESOP transactions, including unallocated leveraged shares:
... the basis of (a) the Leveraged Shares will be the original cost basis to the trust, no matter when such shares are released from the suspense account and allocated; (b) the Forfeited Shares will be the same basis as the basis in the ESOP account from which they were forfeited; (c) the Purchased Shares will be the amount paid by the trust for such shares; (d) the Contributed Shares will be the fair market value of such shares at the time they were contributed by each participating employer of Company M.
Tracking the cost basis of shares in an ESOP allows participants the opportunity to elect NUA tax benefits. To further complicate NUA determination, stock of an S corporation held by an ESOP is subject to the same basis adjustments required by any other S corporation shareholder, which will be discussed in an upcoming blog. Detailed recordkeeping of the stock transactions and related cost basis on an annual basis is a best practice and will alleviate frustration and inaccuracy in the future.