Charitable Planning With Lump Sum Distributions

Charitable Planning With Lump Sum Distributions

Article posted in Retirement Plans on 6 December 2000| comments
audience: National Publication, Dan Rice, Philanthropy Architect | last updated: 3 March 2016


A potentially useful lifetime charitable giving technique for donors who own appreciated employer stock in a qualified retirement plan is described in this article by Dan Rice. As the article explains, the technique involves obtaining favorable tax results for the transfer of the stock to a charitable remainder trust when the stock is distributed from the plan in a lump sum distribution during the donor's lifetime.

By Dan Rice

Many gift planners know all about the income and estate tax benefits of making a testamentary charitable gift of "income in respect of a decedent"1 (IRD) assets--most notably retirement plan assets. And, while some donors are bravely willing and could afford to give away their retirement assets during life, this is not always tax-wise. Current laws (which hopefully may soon change) require that even if the donor currently transfers the retirement plan to charity, the donor must also report the entire plan account balance as taxable income that year.

However, there is a wonderful exception to the usual testamentary charitable gift planning solution for retirement plan assets. If the donor participates in a fairly common company retirement plan that is funded mainly with employer stock, the donor may qualify to make current and deferred charitable gifts of that stock and completely avoid having to report his or her retirement account value as taxable income, like other retirement plans require.

This article briefly describes the special tax treatment for the so-called "lump sum distributions" of employer securities from qualified retirement plans. We will primarily focus on planning opportunities using the Charitable Remainder Trust. The reader is forewarned by Natalie Choate, in her highly recommended book, Life and Death Planning for Retirement Benefits: "A person who wishes to obtain this special treatment is confronted with some of the most convoluted requirements known to post-ERISA man."

Let's begin by meeting Lucy, who is 60. Lucy's in the skyscraper with Diamonds, a Fortune 500 chemical company. Diamonds offers its employees a qualified IRC2 §401(a) retirement plan (these plans include pension, profit sharing or stock bonus plans), which can qualify for special lump sum distribution (LSD) treatment under IRC §402(e)(4)(D)(i).

Lucy has just told you she plans to retire and take LSD from her IRC §401(k) plan. Her LSD consists entirely of 10,000 shares of Diamonds. The plan's cost basis for that stock is $10 per share; the stock is worth $100 a share. Lucy will receive a Form 1099-R from Diamonds, showing a gross distribution of $1 million and an ordinary taxable income amount of $100,000 (which represents the total cost basis, which was the employer contribution portion). The "net unrealized amount" (NUA) is $900,000. If Lucy sells the stock immediately for $1 million she will have a long term capital gain of $900,000. The capital gains tax could cause her to have a really bad mental trip.

After you gently explain the mind-blowing side effects to Lucy, she decides to give her LSD to a Charitable Remainder Trust (CRT) instead. Why? For starters, the charitable income tax deduction for the CRT remainder value may be structured to entirely offset the immediate ordinary taxable income that represents the cost basis portion. Next, the CRT can sell the Diamonds stock and not pay any capital gains tax on the NUA portion. Lucy's CRT can take the proceeds from the stock sale and diversify into a portfolio of investments, while Lucy reserves a life income.

Planning pointer. An often overlooked aspect of the NUA is that if Lucy dies after taking LSD, and still owns Diamonds stock that she received through the plan distribution, there is no step up in basis in the Diamonds stock. The Internal Revenue Service (IRS) has held that the NUA, like other post-death retirement distributions, constitutes IRD (see Rev. Rul. 69-297, 1969-1 C.B. 131). So, when Lucy's estate beneficiaries sell the employer plan stock, they will pay long term capital gain on the NUA portion of the sales proceeds. The beneficiaries will get an IRC §691(c) deduction for the estate taxes paid on the NUA; this deduction will reduce the capital gain.

Information and Resources for the Gift Planner

Who is eligible for LSD / CRT planning? Qualified prospects are employees who have been a plan participant for 5 years, and:

  1. Attained age 59½; or
  2. Terminated service with the employer; or
  3. Are disabled within the meaning of IRC §72(m)(7).

IRC §72(m)(7) defines disabled as follows:

Meaning of disabled. -- For purposes of this section, an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the Secretary may require.3

Who would benefit from LSD / CRT planning?

  1. Highly paid executive nearing retirement;
  2. Who is a participant in a stock bonus or self-directed profit sharing plan allowing investment in employer securities;
  3. Whose company stock has had substantial appreciation.

Recommended Reading

  1. Book: Life and Death Planning for Retirement Benefits, 3rd Edition, 1999, by Natalie B. Choate. Published by Ataxplan Publications, PO Box 1093-K, Boston, MA 02103-1093. Website:
  2. Private Letter Ruling 199919039, issued February 16, 1999.

Private Letter Ruling 199919039 illustrates the transaction described above quite nicely. In this Ruling, Corporation A merged into Corporation B in an IRC §368 tax-free transaction in 1997. Prior to the merger, the taxpayer was the president and chief executive officer of Corporation A and was also on Corporation A's board of directors. Subsequent to the merger, the taxpayer became the vice-chairman and a board member of Corporation B and chief executive officer of some of the Corporation A businesses that had became divisions of Corporation B. The taxpayer planned to separate from employment at Corporation B by December 31, 1998, and would have reached age 55 but not age 59½ by that time. However, the taxpayer would continue to serve on Corporation B's board of directors as an independent contractor. At the time of the merger, each Corporation had one class of stock in its authorized capital.

Prior to the merger, the taxpayer had participated in Corporation A's qualified retirement plan (Plan X) for more than 5 years and the entire balance of the taxpayer's account consisted of Corporation A stock. After the merger, Plan X was merged into Corporation B's qualified profit-sharing plan (Plan Y) which had a cash or deferred arrangement for its employees. The taxpayer became a participant in Plan Y and the Corporation A stock in the retirement plan was exchanged for Corporation B stock. The taxpayer was to receive a distribution from Plan Y at his retirement from employment at Corporation B.

The taxpayer planned to rollover a portion of the retirement plan to an individual retirement account and to receive a distribution of the remainder of the plan as a lump sum distribution. The taxpayer then planned to give a portion of the distributed stock to a CRT. The amount of Corporation B stock contributed to the CRT would not exceed 10% of Corporation B's outstanding stock. The taxpayer and his wife would be the non-charitable lifetime beneficiaries of the CRT. An unrelated person would serve as initial trustee of the CRT.

The IRS ruled favorably on the taxpayer's behalf. First, the IRS held that the portion of the distribution from Plan Y rolled over to the taxpayer's individual retirement account qualified as a tax-free rollover under IRC §402(c) and 401(a)(31) and the portion which was not rolled-over to the taxpayer's individual retirement account constituted a taxable lump sum distribution under IRC §72. However, because the distribution consisted of securities of the taxpayer's employer, Corporation B, the distribution qualified for the exception to the general rule of taxation under IRC §402(a). As a result, the NUA on the stock could be excluded from the taxpayer's gross income pursuant to IRC §402(e)(4)(B). Specifically, the IRS stated:

Section 402(e)(4)(B) of the Code expands on section 402(d)(1) to provide that, for purposes of sections 402(a) and 72, in the case of a lump sum distribution which includes securities of the employer corporation, there shall be excluded from gross income the NUA attributable to that part of the distribution which consists of securities of the employer corporation.

Accordingly, with respect to ruling request 2, assuming that you satisfy the Code requirements for separation from the service of Corporation B for purposes of a lump sum distribution, we conclude that the distribution in 1998 of your entire account balance in Plan Y will meet the requirements of a distribution, within one taxable year of the recipient, of the balance to the credit of your account in Plan Y within the meaning of sections 402(d)(4)(A) and 402(e)(4)(D) of the Code, despite the profit-sharing contribution from Plan Y that is payable to you in 1999 for the 1998 plan year.

With respect to NUA, section 1.402(a)-1(b)(2)(i) of the Regulations provides that the amount of NUA in securities of the employer corporation which are distributed by the trust is the excess of the market value of such securities at the time of distribution over the cost or other basis of such securities to the trust. Thus, if a distribution consists in part of securities which have appreciated in value and in part of securities which have depreciated in value, the NUA shall be considered to consist of the net increase in value of all of the securities included in the distribution.

Section 402(e)(4)(C) of the Code provides that, for purposes of subparagraph (B), NUA and the resulting adjustments to basis shall be determined in accordance with regulations prescribed by the Treasury Secretary.

Accordingly, with respect to ruling request 3, we conclude that NUA within the meaning of section 402(e)(4) of the Code is the difference between the cost basis and the fair market value on the plan distribution date of non-rolled over stock, thus, you will not recognize ordinary income under section 402(e)(4)(B) of the Code on that portion of non-rolled over stock representing NUA.

As to ruling request 5, section 402(e)(4)(B) of the Code provides that where a lump sum distribution includes securities of the employer corporation, the NUA attributable to such distributed securities shall be excluded from gross income.

Notice 98-24, 1998-17 I.R.B. 5 provides that the amount of NUA which is not included in the basis of the securities in the hands of the distributee at the time of distribution is considered a gain from the sale or exchange of a capital asset held for more than 18 months to the extent that such appreciation is realized in a subsequent taxable transaction. The actual period that an employer security was held by a qualified plan need not be calculated in order to determine whether, with respect to the NUA, the disposition qualifies for the rate for capital assets held for more than 18 months. However, with respect to any further appreciation in the employer securities after distribution from the plan, the actual holding period in the hands of the distributee determines the capital gains rate that applies.

Accordingly, with respect to ruling request 5, we conclude that any taxable gain on the subsequent sale of the non-rolled over stock distributed, as described, from Plan Y will be treated as capital gain income on the sale of a capital asset held in excess of 18 months, to the extent of the original NUA, regardless of the time period between the date of distribution from Plan Y and the date of sale provided that the current law is in effect at the time of such sale. We conclude further that any post-distribution gain in excess of the NUA amount will be taxed at the applicable capital gain rate based on the actual holding period of the stock from the date of distribution from Plan Y and the date of sale provided that the current law is in effect at the time of such sale.4

Among other rulings given, the IRS also concluded that the taxpayer would not recognize gain or loss on the contribution of the stock to the CRT and the stock would retain the taxpayer's cost basis and holding period for purposes of calculating any gain on a subsequent sale by the CRT. However, the IRS indicated that any gain from a subsequent sale would be exempt from taxation by the CRT, the taxpayer or the taxpayer's wife and the 4-tier system under IRC §664(b) would apply for purposes of characterizing distributions to the CRT income beneficiaries.

PowerPoint Presentation

The CTAC CRT Employer Stock Show can be downloaded by clicking here.

  1. See IRC §691.back

  2. All references to the IRC are to the Internal Revenue Code of 1986, as amended from time to time.back

  3. IRC §72(m)(7).back

  4. PLR 199919039 (Feb. 16, 1999).back

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