- EMPLOYEE BENEFITS & PENSIONS
Stock-based compensation: Back to basics
- Employee Benefits
- Types & Qualifications
Editor: Kevin D. Anderson, CPA, J.D.
Many companies find stock - based compensation is a great way to attract and retain key employees. Over the past year, many employers focused primarily on changes from the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115 - 97 . Now that the TCJA dust has settled a bit, it may be a good time for employers to go back to basics and review some important but complex tax rules involving compensatory transfers of employer stock. This discussion summarizes some fundamental income tax considerations for employers related to stock - based compensation under U.S. federal income tax laws.
The most common forms of stock - based compensation are restricted stock awards (RSAs), restricted stock units (RSUs), nonqualified stock options (NQSOs), and incentive stock options (ISOs). Each type is treated differently for tax purposes, and each has its advantages and disadvantages. The table "Tax Consequences of Employer Grants," below, summarizes the tax implications for employers for each type of grant.
Restricted stock awards
RSAs are shares of company stock that employers transfer to employees, usually at no cost, subject to a vesting schedule. When the stock vests, the fair market value (FMV) of the shares on that date is deductible by the employer and constitutes taxable W - 2 wages to the employee. Typically, employers withhold applicable federal, state, and local income tax and Federal Insurance Contributions Act (FICA) taxes from the employee's other taxable income, but there are other options. For example, employees may remit cash (or other vested stock) to the employer to cover the taxes, or the employer may withhold some of the newly vested shares with a value equal to the amount of the taxes.
If an employee makes an irrevocable election under Sec. 83(b) within 30 days after the RSA grant, the employee would recognize taxable income immediately on the grant date without having to wait for the shares to vest. This election may be attractive for employees of companies where the stock value is expected to increase, since the election could minimize ordinary income and maximize capital gain when the stock is eventually sold. But Sec. 83(b) elections must be used with caution, since employees cannot get a refund of taxes paid if the stock does not vest or if the value declines after its grant date.
Restricted stock units
RSUs are a promise from the employer to deliver stock or cash to the employee in the future, based on the stock's performance. Since RSUs are not property, they are not governed by Sec. 83. Accordingly, there are no tax implications when employers grant RSUs. Rather, RSUs are deferred compensation taxed under Sec. 451 and are also potentially subject to penalties under Sec. 409A. Pursuant to Sec. 451, when RSUs are actually or constructively paid to the employee, the employer may take a compensation tax deduction equal to the wage income recognized by the employee (i.e., generally, the amount reported on Form W - 2 , Wage and Tax Statement ). The employer is required to withhold applicable federal, state, and local income taxes from RSU payouts.
Unlike RSAs, RSUs are subject to the Sec. 3121(v)(2) special timing rules for FICA taxes on deferred compensation. If the RSU permits, the employer may defer delivering the RSU payout (which may be in cash or in shares) to the employee to a date beyond the vesting date (but the employee may need to make a timely election to defer receipt). So, both the employer and employee shares of FICA are typically due when RSUs vest, even if the payment of the RSUs does not happen until a later tax year.
Incentive stock options
ISOs are preferred by employees when long - term capital gain rates are lower than ordinary income rates, because there is no taxable compensation when ISO shares are transferred to an employee and 100% of the stock's appreciation is taxed to the employee as capital gains when sold.
Both employers and employees must satisfy many requirements laid out in Secs. 421, 422, and 424 and the regulations thereunder for the employee to obtain the favorable tax treatment. Requirements for the grant to qualify as an ISO include (but are not limited to):
- The option price must be at least the FMV of the stock at the grant date;
- The option must be granted pursuant to a written plan that generally must be approved by the shareholders within 12 months before or after the date the plan is adopted;
- Grants are only to employees and are generally nontransferable;
- The option plan term does not exceed 10 years, and the employees must exercise the option within 10 years of the grant date;
- The total FMV of the stock options that first become exercisable is limited to $100,000 in any calendar year; and
- The employee must not dispose of the ISO shares sooner than two years after the grant date and one year after the exercise date .
If all of the ISO requirements are met, the employer would never get a tax deduction for the ISO stock compensation. However, if any of the ISO conditions are not satisfied, the ISO is treated as an NQSO (see below for taxation of NQSOs). Upon a "disqualifying disposition" of an ISO, the proceeds up to the FMV of the shares on the exercise date, less the exercise price paid by the employee, will be taxable compensation income to the employee. The proceeds from a disqualifying disposition in excess of the shares' FMV on the exercise date will be taxed to the employee as a long - term or short - term capital gain, depending on the time the shares are held after exercise.
Upon a disqualifying disposition, the employer is entitled to a tax deduction equal to the taxable compensation reported on the employee's Form W - 2 (in fact, the deduction is contingent upon reporting the income on Form W - 2 ). Employers are not required to withhold income taxes on the amount of taxable compensation created by a disqualifying disposition of stock that was acquired through the exercise of ISOs (Sec. 421(b)).
Nonqualified stock options
NQSOs are stock options that are not ISOs. The tax treatment of NQSOs is generally governed by Sec. 83 unless Sec. 409A applies. Application of Sec. 409A is avoided when the exercise price is no less than the stock's FMV on the grant date. Because most compensatory NQSOs do not have a readily ascertainable FMV on the grant date, they are not considered "property" on the date of grant under Sec. 83 and are not eligible for an 83(b) election. Therefore the taxable event generally occurs when the NQSO is exercised. However, there is a special rule that could delay the taxable event beyond the NQSO exercise date. If the stock acquired upon exercise of the NQSO is subject to a substantial risk of forfeiture (e.g., if the stock is subject to a vesting schedule) and a Sec. 83(b) election is not made with respect to that stock, then the taxable event occurs when the substantial risk of forfeiture lapses (e.g., when the stock becomes vested).
If the taxable event occurs on exercise of the NQSO, the employer is entitled to an ordinary compensation deduction equal to the amount of ordinary income recognized by the employee on the spread between the FMV of the stock on the exercise date and the option exercise price. The employer is also required to withhold the applicable federal, state, and local income taxes, as well as FICA taxes (and pay the employer's share of employment taxes), on the compensation at that time.
If the taxable event occurs when the stock received from the exercise of the NQSO vests, the employer is entitled to an ordinary compensation deduction equal to the amount of ordinary income recognized by the employee on the spread between the FMV of the stock on the vesting date and the option exercise price. The employer is also required to withhold the applicable federal, state, and local income taxes, as well as FICA taxes (and pay the employer's share of employment taxes), on the compensation at that time.
Opportunity to defer payment of taxes
New Sec. 83(i), enacted as part of the TCJA, allows employees of certain privately held companies to elect to defer the payment of income taxes on certain equity compensation for up to five years. The amount of tax owed by the employee is calculated on the taxable event and compensation amount as described above, with only the remittance of the tax being delayed by the Sec. 83(i) election. The delayed payment by the employee in turn delays the employer's tax deduction to the year in which the employee's tax is paid. Plans of qualifying employers are not automatically subject to these deferral rules.
Grants to independent contractors
All of the above - mentioned awards, except for ISOs, are available for awards to independent contractors. Tax reporting for independent contractors is on Form 1099 - MISC , Miscellaneous Income , not Form W - 2 .
Consider tax effects
Employers can attract or retain employees by compensating them with employer stock. There are a few different kinds of compensatory stock - based awards to consider, and each has advantages and disadvantages. When considering what equity - based compensation to offer, employers and their advisers need to analyze thoroughly the tax impacts on both the company and its employees.
Kevin D. Anderson , CPA, J.D., is a partner, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or [email protected] .
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.
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- 184.108.40.206.1 Background
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- 18.104.22.168 Determining the Scope/Verifying Prior Law
- 22.214.171.124 Permanency Requirements/Reasons for Termination
- 126.96.36.199 Discontinuance of Contributions
- 188.8.131.52.1 Calculating the Turnover Rate
- 184.108.40.206.2.1 Percentage of Affected Employees
- 220.127.116.11 Proposed Date of Plan Termination
- 18.104.22.168 Frozen Plans
- 22.214.171.124 Wasting Trust Procedures
- 126.96.36.199 Forfeitures
- 188.8.131.52 Rollovers
- 184.108.40.206.1 401(k) Plan Distributions
- 220.127.116.11.2 In-Kind Distributions
- 18.104.22.168.1 Terminating Plans with Zero Assets
- 22.214.171.124 Prohibited Transactions
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- 18.104.22.168.1.1 Excess Assets Applied to Participants
- 22.214.171.124.1.2 Reversion of Excess Assets
- 126.96.36.199.1.3 Tax on Reversion
- 188.8.131.52.2 Underfunded DB Plan at Termination
- 184.108.40.206 Minimum Funding Standards
- 220.127.116.11 Adjusted Funding Target Attainment Percentage (AFTAP)
- 18.104.22.168 Interested Party Notices Upon Plan Termination
- 22.214.171.124 PBGC Notice on Plan Termination
Part 7. Rulings and Agreements
Chapter 12. employee plans guidelines, section 1. plan terminations, 7.12.1 plan terminations, manual transmittal.
November 10, 2022
(1) This transmits revised IRM 7.12.1, Employee Plans Guidelines, Plan Terminations.
(1) Updated IRM 126.96.36.199 (6) to provide that partial termination relief applies to the entire year even if part of the plan year falls outside the date range of March 13, 2020 to March 31, 2021.
(2) Added IRM 188.8.131.52 (1) , Note, to provide reference to Section 306 of the Protecting America from Tax Hikes Act which amended IRC 408(p)(1)(B) to expand the types of plans from which SIMPLE IRAs can accept rollovers.
(3) Updated IRM 184.108.40.206 (1) to provide that in the event of plan termination, assets in the trust after satisfaction of the funding standards are allocated to participants under Section 4044 of ERISA. This applies whether the plan is overfunded or underfunded.
(4) Updated IRM 220.127.116.11 (4) to provide that in the case where the assets equal liabilities, the specialist must determine why that is the case.
(5) Updated IRM 18.104.22.168.1 (4) to state that in the case of a "spin-off/termination" , generally no termination will be recognized and any attempt to recover surplus assets will be treated as a diversion of assets for a purpose other than the exclusive benefit of employees and beneficiaries unless certain conditions are met.
(6) Updated IRM 22.214.171.124.1.1 (1) to provide that a majority owner may not forego their benefit to create a larger reversion because it violates the anti-alienation requirements of ERISA, Section 206(d)(1), and IRC 401(a)(13).
(7) Updated IRM 126.96.36.199.1.2 (3) to provide a surplus accumulated as a result of a change in the benefit provisions or in the eligibility requirements of a plan is not the result of an erroneous actuarial computation.
(8) Updated IRM 188.8.131.52.1.2 (3) b) to state the requirements for a plan to be considered a qualified replacement plan in order to receive a direct transfer of excess plan assets.
(9) Updated IRM 184.108.40.206.2 (4) to state that all plans subject to ERISA, upon termination, must allocate trust funds according to ERISA 4044.
(10) Updated to reflect current versions of annual revenue procedures.
Effect on Other Documents
Eric D. Slack Director, Employee Plans Tax Exempt and Government Entities
Program Scope and Objectives
Purpose: To provide procedures and technical guidance on issues EP employees may have when reviewing Determination Letter (DL) applications for terminating and terminated retirement plans.
Audience: Employee Plans (EP) Determinations and Quality Assurance (QA) staff
Policy Owner: Director, EP
Program Owner: EP
Program Goals: The goal of EP Determinations is to:
Ensure that plans comply with the tax laws by reviewing applications for DLs and opinion letters.
Protect the public interest by applying the tax law with integrity and fairness to all.
Plan sponsors who terminate their plans or have potential partial terminations may submit requests for a DL using the following forms:
Form 5310, Application for Determination for Terminating Plan.
Form 5300, Application for Determination for Employee Benefit Plan, when requesting a ruling on a partial plan termination.
Form 5300, Application for Determination for Employee Benefit Plan, for termination of collectively bargained multiemployer or multiple employer plan covered by Pension Benefit Guaranty Corporation (PBGC) insurance.
When reviewing an application for a full or partial termination, complete:
Form 5621, Technical Analysis Control Sheet.
Form 6677, Plan Termination Standards Worksheet.
Any other appropriate forms or worksheets.
Use this IRM with IRM 7.11.1, Employee Plans Determination Letter Program, which gives general DL application processing procedures.
These acronyms are used in this IRM:
Determining the Scope/Verifying Prior Law
For individually designed plans (IDPs), with a FDL, verify that the form of the plan was properly amended for prior legislation. Begin your review with the last FDL.
It gives reliance for a CL so you only need to secure subsequent interim amendments up to the final 2015 CL and verify they were timely adopted.
After satisfying a), continue verifying compliance with the applicable items on all the Required Amendment Lists (RA List).
After satisfying b), verify compliance with any required provision or a provision that the employer has elected to put in place operationally, including items on the operational compliance list, effective on or after January 1, 2016 up through the date of termination.
A plan sponsor submits a Form 5310 application on March 15, 2021, and has a FDL that covers the 2013 CL. Start your review by verifying that the plan timely complied with the interim amendments for 2014 and 2015. Verify compliance with all provisions effective up to the date of termination. This would include any items on the RA List and any required or employer-elected provisions that were effective on or after January 1, 2016, that the employer elected to put in place operationally.
A plan sponsor submits a Form 5310 application on June 15, 2021, and has a FDL that covers the 2008 CL. Start your review by verifying the plan timely complied with the interim amendments for 2009 through 2015. Verify compliance with all provisions effective up to the date of termination. This would include any items on the RA List and any required or employer-elected provisions that were effective on or after January 1, 2016, that the employer put in place in the plan’s operation.
For individually designed plans (IDPs), with no FDL, verify that the form of the plan was properly amended for prior legislation.
Secure and verify the form of the plan was timely amended to comply with all interim amendments listed on the CL applicable for the 2nd cycle, based on the last digit of the employer’s EIN, and the subsequent interim amendments up to the final 2015 CL.
After satisfying a), continue the review by verifying compliance with: The applicable items on all RA Lists, and Any required provision or a provision that the employer has elected to put in place operationally, including items on the operational compliance list, effective on or after January 1, 2016, up to the date of termination.
A plan sponsor submits a Form 5310 application for a PS plan on March 31, 2022 which has been in existence since 2007. Secure and verify the interim amendments included on the CL for the 2nd cycle (2007-2011) and the subsequent interim amendments through 2015 are timely adopted. The restatement submitted is effective January 1, 2016 and signed August 20, 2016. There is no FDL and the last digit of the employer’s EIN is a 2.
After verifying CL requirements, verify compliance with all provisions effective up to the date of termination. This would include any items on the RA List and any required or employer-elected provisions that the employer made effective and put into operation or after January 1, 2016.
For pre-approved plans, verify the form of the plan complied with:
The applicable interim amendments on the CL for which the latest advisory or opinion letter was issued. If the pre-approved sponsor did not have the authority to adopt amendments on behalf of the employer (Power to Amend), secure the subsequent interim amendments up to the date of termination.
The CL for the prior cycle for which the employer satisfied by submitting the adoption of prior pre-approved document or a FDL.
The applicable items on all RA Lists.
Any required provision or a provision that the employer has elected to put in place operationally, including items on the operational compliance list, effective on or after January 1, 2016 up through the date of termination.
The case should be documented to include how they were entitled to the six-year cycle by either being a prior or new adopter of a pre-approved plan as the initial plan.
A termination application was submitted for a pre-approved DB plan with a proposed DOT of 10-1-21. The application included a restated plan which includes the Power to Amend, effective 1-1-20 and signed 6-30-20 which complied with the 2012 CL and based on the latest advisory letter. The latest pre-approved sponsor also has the Power to Amend, so no subsequent interim amendments would be required to be secured. There is a FDL for the prior pre-approved M&P plan which covered the 2006 CL; this would satisfy how the plan was entitled to the six-year cycle as they were a prior adopter.
Same facts above, but the latest plan did not have the Power to Amend, so the items on the 2013 CL and later must be secured and verified. Again, the prior plan was a pre-approved M&P plan, which automatically has the authority to adopt all interim amendments (the Power to Amend) and would have been a prior adopter entitled to the six-year cycle.
A Form 5310 is received on 10-1-21. The application is for a 401(k) plan with a proposed DOT of 9-30-21. The established date of the plan is 1-1-02 and there is no FDL. The submitted restated plan was signed on 5-28-15 and the advisory letter is dated 3-31-14 which satisfies the 2010 CL. The VS document provided for the Power to Amend and submitted copies of the interim amendments for 2011 up through the DOT. The amendments reflect the required provision or a provision that the employer has elected to put in place operationally, including items on the operational compliance list, effective on or after January 1, 2016 up through the date of termination. These amendments are needed to verify compliance up through the DOT. The prior plan document will still need to be secured to verify if it was a pre-approved plan which would have given them entitlement to the six-year cycle.
If you can’t verify prior law, ask the plan sponsor to provide:
The current and prior plan document or adoption agreement (including any applicable opinion or advisory letters).
All interim amendments applicable for the 2nd cycle up through the 2015 CL, and,
If you aren’t requesting any other information or if the POA/plan sponsor can’t find the FDL, review EDS, TEDS, IDRS (EMFOLL) to determine if the IRS issued a DL to the plan to satisfy the above compliance.
If a plan sponsor isn’t able to prove that the plan was timely amended for prior law, the plan is considered to have a plan document failure as described under Rev. Proc. 2021-30, and may need to enter into a closing agreement to correct the failure. Consult your manager and see IRM 7.11.8, EP Determinations Closing Agreement Program.
Use the Employee Plans - Terminations Focus Reports to determine whether new laws are relevant to a particular terminating plan. Find these reports on the IRS website .
Permanency Requirements/Reasons for Termination
A plan must be established with the intent to be a "permanent" not "temporary" program. (26 CFR 1.401-1(b)(2)).
Review Form 5310, lines 4(d) and 5(a)(2), to determine how long the plan has been in existence.
The prior qualification of a long-established plan and trust is not adversely affected by termination of the plan and trust without business necessity when all benefits are fully vested, are guaranteed, and the termination does not result in a prohibited transaction.
If a plan terminates within a few years after its initial adoption, the plan sponsor must give a valid business reason for the termination or there’s a presumption that the plan was not intended to be a permanent program from its inception. However, the qualification of a long-established plan that terminates without a valid business reason is not adversely affected. See Rev. Rul. 72-239.
Form 5310, line 14 lists the following reasons for plan termination:
Change in ownership by merger.
Liquidation or dissolution of employer.
Change in ownership.
Adverse business conditions (sponsor must attach an explanation).
Adoption of new plan (sponsor must describe the plan type).
Form 5310, line 14 also has a section for "Other" reasons for the plan termination. Other acceptable business reasons for plan termination could be:
Substantial change in stock ownership.
Employee dissatisfaction with the plan.
Bankruptcy of employer.
When a plan sponsor lists any reason in "Other," review all the surrounding facts and circumstances and determine whether the plan was intended to be permanent. Consider the extent of any tax advantages the employer derived when the plan existed.
Form 5310, line 19 is also used to determine permanency. Repeatedly failing to make contributions in a discretionary profit-sharing plan may indicate the employer lacked intent for the plan to be permanent.
Consult with your manager if you determine that there is a possible permanency issue.
If bankruptcy is the reason for termination for a pension plan:
Review Form 5310, line 17(h) to determine if there’s a funding deficiency or if the plan sponsor owes excise taxes.
To verify the plan sponsor filed Form 5330 for excise taxes, get EMFOLT on the Integrated Data Retrieval System (IDRS) for Form 5500, Annual Return/Report of Employee Benefit Plan, for the year of the deficiency and look for TC 154, which lists the excise taxes filed for that year.
To verify the plan sponsor paid the excise tax, go to BMFOLI and look for MFT code 76 to see the excise taxes filed for the current taxable year and other taxable years. Get a BMFOLT screen print for a specific plan year’s transcript.
If the plan has a funding deficiency on Schedule SB and IDRS confirms they didn’t file Form 5330 and pay the excise taxes due, contact the bankruptcy coordinator for the state that the plan sponsor does business in.
The bankruptcy coordinator will tell you the insolvency bankruptcy specialist assigned to the plan sponsor's bankruptcy case.
Refer the case to EP Examinations using the procedures in IRM 7.11.10, EP Examination and Fraud Referral Procedures, to calculate the excise tax and report that amount to the bankruptcy specialist BEFORE the bar date.
EP Examinations must calculate the excise tax because it is an operational issue.
Don’t make a referral if the bar date has passed because we can no longer collect excise taxes after that date. Document the Form 5621 with your explanation.
See IRM 5.9, Bankruptcy and Other Insolvencies.
Discontinuance of Contributions
This section only applies to plans not subject to IRC 412, such as profit sharing and stock bonus plans. For plans subject to IRC 412, see IRM 220.127.116.11 , Minimum Funding Standards.
Pursue a possible discontinuance of contributions only if there are participants who had forfeitures during the years under consideration. See Form 5310, line 19(b).
If the plan sponsor stops making contributions or makes contributions that aren't substantial, the plan may have incurred a complete discontinuance. A profit sharing plan must make recurring and substantial contributions for employees. (26 CFR 1.401-1(b)(2)).
A plan may have had a complete discontinuance of contributions even if the plan sponsor made contributions, but the amounts aren’t substantial enough to reflect the plan sponsor’s intent to continue to maintain the plan. (26 CFR 1.411(d)-2(d)(1)).
Review Form 5310, line 19a, which indicates the employer contributions made for the current and the five prior plan years, to determine if the plan has had a complete discontinuance.
Consider all of a case’s relevant facts and circumstances; but generally, in a profit-sharing or stock bonus plan, consider the issue of discontinuance of contributions if the plan sponsor has failed to make substantial contributions in three out of five years.
A complete discontinuance (under 26 CFR 1.411(d)-2(d)(2)) becomes effective:
For a single employer plan, the last day of the employer’s tax year after the tax year for which the employer last made a substantial contribution to the profit-sharing plan.
For a plan maintained by more than one employer, the last day of the plan year after the plan year within which any employer last made a substantial contribution.
If the plan has incurred a complete discontinuance, all affected employees’ rights to benefits accrued to the date of discontinuance, to the extent funded as of that date, or the amounts credited to the employees’ accounts at that time, must be nonforfeitable (100% vested). See IRC 411(d)(3) and CFR 1.411(d)-2(a)(1)(ii).
Upon partial termination, all "affected employees" rights to all amounts credited to their account, and benefits accrued up to the date of the termination, become nonforfeitable. (IRC 411(d)(3)).
Only pursue a possible partial termination if there were participants who had forfeitures during the years under consideration.
If a partial termination occurs on account of turnover during an applicable period, all participating employees who had a severance from employment during the period must be fully vested in their accrued benefits, to the extent funded on that date, or in the amounts credited to their accounts. (Rev. Rul. 2007-43).
To determine if a plan has had a partial termination, first calculate the turnover rate (See IRM 18.104.22.168.1 , Calculating the Turnover Rate) but also consider all of a case’s relevant facts and circumstances.
There’s a presumption that a qualified plan has partially terminated when the turnover rate for participating employees is at least 20%. If the turnover rate is less than 20%, it depends on the case’s facts and circumstances. (Rev. Rul. 2007-43).
Partial Termination Relief: Section 209 of the Taxpayer Certainty and Disaster Tax Relief Act of 2020 and Division EE of the Consolidated Appropriations Act of 2021 states that a plan isn’t considered to have a partial termination during any plan year which includes the period beginning on March 13, 2020, and ending on March 31, 2021, if the number of active participants the plan covered on March 31, 2021 is at least 80% of the number of active participants the plan covered on March 13, 2020.
Partial Termination Relief applies during any plan year if any part of the plan year falls within the period beginning on March 13, 2020, and ending on March 31, 2021. Relief applies to the entire year even if part of the plan year falls outside the date range. For example, for a calendar year plan, the 80% test applies to both the 202012 plan year and the 202112 plan year, because both plan years include a part of the statutory 3/13/2020 - 3/31/2021 relief period. Also, determine the 80% by looking strictly at the number of active participants on each date, without regard to whether they were the same individuals. This allows for consideration of new hires.
Some facts and circumstances to consider when you decide if a plan has had a partial termination:
A plan may have a high turnover rate as part of its normal routine. Consider these facts to determine if the turnover is routine for a particular plan sponsor: • The turnover rate in other periods. • The extent to which terminated employees were actually replaced. • Whether the new employees performed the same functions, had the same job classification or title, and received comparable compensation.
If there’s a significant increase in the turnover rate for a period, the plan may have incurred a partial termination.
Consider if the plan has increased its possibility for prohibited discrimination.
If a DB plan’s cessation or reduction of future benefit accruals creates or increases a potential for reversion, the plan is deemed to have a partial termination.
Calculating the Turnover Rate
Review Form 5310, line 16(a) to determine the turnover rate.
The turnover rate = a)/b)
The number of participating employees who had an "employer-initiated severance from employment" during the applicable period.
The sum of all of the participating employees at the start of the applicable period plus the employees who became participants during the applicable period.
The applicable period can be the:
For a plan year with less than 12 months– the plan year plus the immediately preceding plan year.
A longer period if the employer has had a series of related severances from employment.
See Tipton and Kalmback, Inc. v. Commissioner , 83 TC 154 (1984); and Weil v. Retirement Plan Admin. Comm. of Terson Co. , 933 F.2d 106, (1991).
Turnover rate factors:
Consider all participating employees to calculate the turnover rate, including vested and nonvested participating employees.
"Employer-initiated severance from employment" generally includes any employee who severed from employment for a reason other than death, disability, or retirement on or after normal retirement age.
A severance from employment is employer- initiated even if it was caused by an event outside the employer’s control such as terminations due to depressed economic conditions.
The employer may be able to prove that an employees' severance was voluntary (not employer-initiated) by providing information from personnel files, employee statements, or other corporate records.
Examples of Partial Termination
Employer discharging 95 of 165 participants under the plan in connection with dissolving one division of the employer’s business. (Rev. Rul. 81-27).
Employer discharging 12 of 15 participating employees who refused to transfer to the employer’s new business location when the old location was closed. (Rev. Rul. 73-284).
Reduction in participation of 34 percent and 51 percent in consecutive years where adverse business conditions beyond the employer’s control resulted in participation reductions. See Tipton and Kalmbach, Inc. v. Commissioner , 83 TC 154, 5 EBC 1976 (1984).
Relocation of two of an employer’s 16 divisions resulting in the termination of over 75% of the employees in the affected divisions, and termination of 27% of the total plan participants. See Weil v. Terson Co. Retirement Plan Committee , 750 F.2d 10, 5 EBC 2537 (2nd Cir. 1984).
Percentage of Affected Employees
In the partial termination examples (above), a significant percentage of employees were excluded from participating in the plan.
Matz v. Household International Tax Reduction Investment Plan , 388 F.3d 570 (7th Cir. 2004) held that there is a rebuttable presumption that a 20% or greater reduction in plan participants is a partial termination for purposes of IRC 411(d)(3). Consider each case's facts and circumstances, including the extent to which terminated employees are replaced, and the business’s normal turnover rate in a base period.
The base period ordinarily should:
Be a set of consecutive plan years (at least two) from which you can determine the normal turnover rate.
Reflect a period of normal business operations rather than one of unusual growth or reduction.
Include plan years that immediately precede the period in question.
Proposed Date of Plan Termination
The proposed termination date of a plan NOT subject to Title IV of ERISA (DC plans) is the date the plan sponsor who maintains the plan voluntarily terminates it. (26 CFR 1.411(d)-2(c)(3)). Generally, the plan sponsor establishes the proposed termination date by board resolution or plan amendment.
The proposed termination date of a plan subject to Title IV of ERISA (DB plans) is the date determined under ERISA (26 CFR 1.411(d)-2(c)(2)). There are three types of DB terminations under ERISA:
The type of termination can impact the date of the proposed termination.
The DL application must include a copy of the resolution or amendment terminating the plan. If not submitted, request it.
Compare the proposed termination date listed on the resolution or amendment to the date on Form 5310, line 5(a)(2). If the two dates don’t match, reconcile the discrepancy.
The proposed termination date is important because:
All affected participants must be 100% vested as of the proposed termination date.
The plan should be amended for all laws effective as of the proposed termination date.
The plan should be fully funded up to the proposed termination date.
When reviewing the documentation that terminates that plan, verify that the plan hasn’t incurred any IRC 411(d)(6) violations. Generally, this would not be an issue if the plan termination date is after the date the plan sponsor adopts the document to terminate the plan.
The plan sponsor of ABC Company decides to terminate their retirement plan on July 1, 2020, and adopts a resolution on June 25, 2020.
The proposed termination date may not be retroactive except when it won’t reduce any participant's accrued benefit.
For money purchase and target benefit plans, if the plan sponsor adopts an amendment (or resolution) to terminate the plan after the plan termination date and an allocation date falls within this time period, then the employer contribution would still be required.
If a plan sponsor takes actions to terminate a plan but doesn’t distribute the assets as soon as administratively feasible, the plan isn’t considered terminated under IRC 401(a). The plan must remain qualified until it’s terminated.
The minimum funding requirements apply to a plan until its termination date, but 26 CFR 1.430(a)-1(f)(5) clarifies that we defer to the PBGC for the termination date for PBGC-covered plans. For noncovered plans, 26 CFR 1.430(a)-1(f)(5)(ii)(B) states that they’re not considered terminated if the assets aren’t distributed timely, so they’d continue to be subject to minimum funding requirements. See Rev. Rul. 89-87, Treas. Reg. 1.430(a)-1(f)(5), and IRM 22.214.171.124, Wasting Trust Procedures.
A plan isn’t terminated simply because the plan sponsor amends it to cease future accruals or "freezes" it. However this type of amendment may trigger a complete discontinuance of contributions and require increased vesting under 26 CFR 1.411(d)-2(d)(i). See IRM 126.96.36.199 , Discontinuance of Contributions.
If the plan wasn’t terminated after the proposed date of termination, then determine if the plan was qualified as of the actual date of the plan termination. This could occur under the following circumstances:
The assets haven’t been distributed as soon as administratively feasible.
The participants weren’t timely notified of the plan termination.
For plans subject to Title IV of ERISA, the plan sponsor didn’t timely notify PBGC of the plan termination.
A frozen plan is one in which all future contributions or benefit accruals have ceased by plan amendment, but the plan sponsor hasn’t formally terminated the plan. The plan may also freeze participation so that no new employees are eligible to enter the plan. A plan stays frozen until it’s amended to either:
Continue further contributions/accruals.
A frozen plan must continue to meet the requirements of IRC 401(a) (including changes in the law) except for:
Top heavy minimum required contributions for frozen DC plans. This is because key employees receive no benefit so no contribution is required for non-key employees.
Coverage testing is automatically satisfied per 26 CFR 1.410(b)-3.
The Form 5310 doesn't directly ask about frozen plans, however, review line 17(b) to see if an amendment has been adopted which decreases plan benefits to any or all participants. If so, then verify that the amendment doesn’t violate IRC 401(b) or 411(d)(6).
Wasting Trust Procedures
A qualified plan under which benefit accruals have ceased isn’t terminated if assets of the plan remain in the plan's related trust rather than being distributed as soon as administratively feasible (generally within one year) per Rev. Rul. 89-87.
Rev. Proc. 2016-37, Section 4.03(2) states that an application is filed in connection with plan termination only if it is filed no later than the later of one year from the:
Effective date of the termination, or
The date on which the plan sponsor takes action to terminate the plan.
In no event may the application be filed later than 12 months from the date of distribution of substantially all plan assets in connection with the termination of the plan. See IRM 188.8.131.52.1 , Terminating Plans with Zero Assets.
If the Form 5310 application is submitted to the IRS within one year of the effective date of the termination, the plan administrator may generally delay distributing the assets until after the IRS issues the DL. However, a plan administrator may not delay distributing assets because EP Examinations or another IRS unit is examining the employer.
Compare the proposed plan termination date to the DL application's control date. If the control date is within one year of the proposed termination date, there is not a wasting trust issue. If the time between the control date and the proposed termination date exceeds one year (and assets have not been distributed), then there is a wasting trust issue and:
The plan sponsor must select a new proposed termination date.
The plan must continue to meet the requirements of IRC 401(a) until the new proposed date of termination.
Review Form 5310, line 5(b) to determine if distributions will be made as soon as administratively feasible. If not, then:
Inform the plan sponsor that the plan must be continuously amended to comply with all current legislation to remain a qualified plan.
If Form 5310, line 5(b) was answered incorrectly, the application must be revised or a written statement should be secured from the plan sponsor.
If the plan sponsor withdraws the Form 5310, return the case using the procedures in IRM 184.108.40.206, Withdrawal of Applications. If there are potential disqualifying features, refer the case to EP Examinations using the procedures in IRM 7.11.10, EP Examinations and Fraud Referral Procedures.
The date a plan forfeits the non-vested portion of the account balance or accrued benefit depends on the plan terms.
Review Form 5310, lines 16(a)(6) and 19(b). If line 16(a)(6) indicates any participant has terminated employment without full vesting then the information identified on line 16(b) must be submitted.
Form 5310, line 16(a) shows six years of history of all participants who left without full vesting. Reconcile this information to the:
Plan’s forfeiture and vesting terms.
Form 5310, lines 16(a)(6) and 19(b).
If there are any discrepancies or questions, secure additional information from the plan sponsor or their representative, if applicable. If the information on the Form 5310, line 16(a)(6) is incorrect, secure a corrected page to the application.
If you determine that a participant's accrued benefit or account balance has been forfeited incorrectly, obtain a written statement from the plan sponsor indicating they’ve restored the participant's accrued benefit or account balance. Include paragraph 26 on the DL.
Forfeitures from profit sharing, stock bonus or, effective for years after December 31, 1985, money purchase plans, can’t revert back to the plan sponsor. (Rev. Rul. 71-149). Forfeitures must be allocated to the remaining participants or used to reduce the employer contributions that are otherwise required under the plan. See Rev. Rul. 71-313 and Rev. Rul. 81-10.
A DB pension plan can’t use forfeitures to increase benefits before plan termination. See IRC 401(a)(8) and 26 CFR 1.401-7.
A fully insured DB plan may allow for forfeitures after five consecutive breaks in service. However, a forfeiture in a non-fully insured DB plan can only be triggered through a cash-out per IRC 411(a)(7).
Plans under IRC 401(a), IRC 403(b), and IRC 457(b) may receive rollovers from other plans under IRC 401(a)(31) and IRC 402(c). For a plan to accept rollovers, the language must be stated in the plan document.
Section 306 of the Protecting America from Tax Hikes Act (which is Division Q of the Consolidated Appropriations Act, 2016; PL 114-113) amended IRC 408(p)(1)(B) to expand the types of plans from which SIMPLE IRAs can accept rollovers. Previously, a SIMPLE IRA could only accept rollover contributions from another SIMPLE IRA. The new law expands portability of retirement assets by permitting taxpayers to roll over assets from traditional and SEP IRAs, as well as from employer-sponsored retirement plans such as a 401(k), 403(b), or 457(b) plan, into a SIMPLE IRA. Some restrictions do apply.
Review Form 5310, line 19(c) to see if the plan received any rollovers in the last six years. If any amount appears to be questionable or excessive, pursue the issue and follow-up with your manager, if necessary.
Verify if the rollovers were from other qualified plans or traditional IRAs. A rollover can’t be made from Roth IRAs or Designated Roth Accounts to a qualified plan.
Review safe harbor rollover procedures in Rev. Rul. 2014-9 for simplified procedures to reasonably conclude that the rollover is valid. They include:
Employee certifying the source of the funds.
Verifying the payment source (on the incoming rollover check or wire transfer) as the participant’s IRA or former plan.
If the funds are from a plan, looking up that plan’s Form 5500 filing, if any, in the DOL EFAST2 database to make sure the plan is intended to be a qualified plan.
f you discover that the rollover came from a Rollover Business Start-ups (ROBS) arrangement, discuss the case with your manager as additional procedures may apply. See EP Director Memorandum dated October 1, 2008, "Guidelines regarding rollovers as business start-ups" EP Director Memorandum dated October 1, 2008 .
A ROBS is typically a one participant plan that allows the trust to invest in "Qualified Employer Securities."
Mode of Distribution
Qualified plans must state the forms of distribution in which they will pay participants and beneficiaries. Forms of distribution provided by a plan are either stated as a default, or provide for participant or beneficiary election. Neither the employer nor any other fiduciary or third party can exercise discretion to select a participant's or beneficiary’s form of distribution. See 26 CFR 1.411(d)-4, Q&A 4.
Upon plan termination, all plan assets must be distributed as soon as administratively feasible (generally within one year after the date of plan termination). See IRM 220.127.116.11 . Generally, a pending DL application may extend this date; however, an IRS examination of the employer does not. See IRM 18.104.22.168 (3) . Form 5310, line 20 indicates how distributions will be made upon termination. Verify that the payment forms listed on the Form 5310 agree with the plan terms.
If Form 5310, line 20 doesn’t match the plan document, request a corrected Form 5310 or an amendment to the plan.
The plan only allows lump sum distributions but Form 5310 indicates that assets will be distributed in the form of an annuity upon plan termination. Since that likely raises a qualification failure, request that the plan sponsor correct the application or amend the plan document.
If a plan offers a Qualified Joint & Survivor Annuity (QJSA):
The plan must distribute the assets in that form unless the participant (and spouse, if applicable) consent to a different form of benefit (such as a single-sum distribution) per IRC 417(a)(2).
Review line 17(c) to verify that all of the benefit rights were correctly protected as required under IRC 401(a)(11) and IRC 417.
A terminating DC non-money purchase plan that doesn’t offer an annuity distribution option may distribute a participant’s account balance without the participant’s consent, even if the account balance exceeds the involuntary cash-out limit in the plan (26 CFR 1.411(a)-11(e)).
This rule doesn’t apply if the plan sponsor, or a member of its controlled group, maintains another DC plan. In this case, if the participant doesn’t consent to an immediate distribution, the plan sponsor may transfer his/her account balance, without the participant’s consent, to the other plan.
Review Form 5310, line 17(j) when verifying that the plan made distributions correctly. This question lists the largest amount the plan distributed or applied to purchase an annuity contract within the last six plan years. If this line is completed, request additional information to verify that:
The plans terms were followed.
The plan reported the distribution on Form 1099-R.
The plan obtained spousal consent, if applicable.
The plan distributed a rollover to an IRA, 401(a) plan, or another eligible retirement plan (confirm rollover recipient was one of these).
The status of the participant who received the distribution (such as HCE, officer, trustee, owner etc.).
If the plan fails to follow any of the above rules, refer the plan to exam per IRM 7.11.10, EP Examinations and Fraud Referral Procedures. If a distribution to an HCE failed to conform to plan terms, in your referral, cite a potential violation of IRC 401(a)(4) - availability of benefits, rights and features.
401(k) Plan Distributions
A terminated 401(k) plan is prohibited from distributing elective deferrals from a participant's account if the employer maintains or establishes a successor 401(k) plan within a certain period of time from the proposed termination date. (IRC 401(k)(10)(A)). If the terminating plan is a 401(k) plan and the employer:
Has a successor 401(k) plan (see Form 5310, line 17(m)), the elective deferrals must be transferred to that plan. The elective deferrals are kept in the successor 401(k) plan until a distributable event occurs such as a severance from employment.
Doesn’t have a successor plan, the 401(k) plan must distribute elective deferrals in a lump sum distribution according to IRC 401(k)(10)(B) and IRC 402(e)(4)(D).
An "in-kind" distribution is a distribution in a form other than cash.
Examples of in-kind distributions include but aren’t limited to:
If Form 5310, line 17(f) states that the plan will distribute property other than cash and/or readily tradable marketable securities, verify:
That the plan allows in-kind distributions.
That all participants have been given the option of having a distribution in kind.
How assets will be distributed.
How the assets are valued.
If a plan allows in-kind distributions, has invested all or some the assets of the trust in property or stock, and hasn’t liquidated these assets into cash before terminating the plan, the employer must give all participants the option of taking an in-kind distribution of their respective portion of the asset.
Trust Assets/Balance Sheet
Form 5310, line 21 requires plan sponsors to provide a statement of trust assets as of the proposed termination date or the last valuation date.
Add all assets and reconcile them to line 21(f).
If the plan sponsor submits a Form 6088, Distributable Benefits From Employee Pension Benefit Plans, verify that the net assets available on the Form 5310 equal the benefit amounts listed on the Form 6088. If the amounts aren’t equal, reconcile any differences, keeping in mind that assets may be computed using different dates and the Form 6088 may include amounts already distributed.
Form 6088 is only required for DB plans and underfunded DC plans. If a plan is over or underfunded, see IRM 22.214.171.124.1 or IRM 126.96.36.199.2
When reviewing the assets on line 21, consider:
The type of assets.
How they are valued.
When they were contributed.
How they are distributed.
When reviewing the assets on Form 5310, line 21, follow these actions:
Lines 21(g), (h), (i), or (j), plan liabilities. If there are amounts listed on these lines, request:
If the Form 5310 or any documentation submitted with the application indicates that there are issues relating to the plan or trust currently pending before the IRS or another government agency:
Determine whether these issues impact plan qualification.
Discuss the case with your group manager before taking further action.
Document the file to show the actions you considered and your conclusion.
Terminating Plans with Zero Assets
In some cases, a plan sponsor submits a Form 5310 application after they’ve distributed all assets to plan participants and line 21 will show zero plan assets.
In this case, secure written documentation showing the:
Date of distribution of all assets.
Investment allocation of all assets before distribution.
Allocation of assets to participants.
The plan sponsor may not file the Form 5310 application after 12 months from the date they distribute substantially all plan assets in connection with the plan termination per Rev. Proc. 2016-37, Section 4.03(2). ( IRM 188.8.131.52 (2) ).
Therefore, if the plan distributed assets more than one year before they filed Form 5310 (use the 5310 control date), return the case using a Letter 1924. Use selectable paragraph "1" with a variable of "Rev. Proc. 2016-37."
If the plan sponsor filed the application within 12 months from the date the assets were distributed, follow the normal case processing procedures.
If you determine there is a PT, refer the case to EP Examinations using the procedures in IRM 7.11.10, EP Examinations and Fraud Referral Procedures, to ensure that the disqualified person pays the proper taxes and the PT is corrected. See IRM 4.72.11, Prohibited Transactions.
Unrelated Business Income (UBI)
A qualified trust under IRC 501(a) generally is exempt from tax on any income derived from the "intended activity," which is investing and saving for retirement.
However, if the plan or trust is involved in generating any income outside it's "intended activity," that amount is considered UBI and is subject to tax.
A common source of UBI is when a trust invests in either a partnership or joint venture. IRC 512(c) notes that the trust's share of the partnership income should be treated as if it were carrying on the trade or business of the partnership. Therefore, unless the income meets one of the exclusions in IRC 512(b), it’s considered UBI for the trust.
If you determine that the trust has possible UBI, refer the case to EP Examinations per IRM 7.11.10, EP Examination and Fraud Referral Procedures.
Life Insurance Contracts
Plans can use life insurance to fund the retirement plan as either an "incidental" benefit or the sole benefit. See IRM 184.108.40.206.2 , Fully Insured Contract Plans, if 100% of the trust's assets are invested in insurance or annuity contracts.
If a plan isn’t a fully insured contract plan, then the life insurance must meet the requirements to be considered an "incidental" benefit to the main purpose of retirement benefits in the plan. For life insurance coverage to be incidental:
For a DC plan, the amount of total premiums for ordinary whole life insurance must be less than 50% of the annual contribution. The figure is 25% for term or universal life insurance.
For a DB plan, the insurance face value generally can’t exceed 100 times the participant's projected monthly retirement benefit (Other methods are possible. See Rev. Rul. 68-453 and Rev. Rul. 74-307).
If Form 5310 line 21(c)(12) shows that plan assets are invested in life insurance contracts, check if the plan is a fully insured contract plan. If the plan isn’t a fully insured contract plan, reconcile the assets and ensure that the benefits are incidental to the plan's main purpose of providing a retirement benefit (and not solely a death benefit).
Ask if the life insurance contracts are springing cash value contracts. See IRM 220.127.116.11.1 , Springing Cash Value.
Springing Cash Value
Some firms have promoted an arrangement where an employer sets up a fully insured contract plan, makes and deducts contributions to the plan, and then uses the contributions to purchase specially designed "springing cash value" life insurance contracts. Generally, these special policies are available only to highly compensated employees.
Fully insured contract plans are described in IRC 412(e)(3).
A "springing cash value" insurance contract may be designed so that the policy’s stated Cash Surrender Value (CSV) for a specified number of years (for example, the first 5 years) is very low compared to the plan assets used to purchase the contract. When the CSV is low, the plan distributes the policy to the employee; however, the contract is structured so that the CSV increases significantly after it’s transferred to the employee.
A springing cash value life insurance policy gives employers tax deductions for amounts far in excess of what the employee recognizes in income and aren’t permitted.
The IRS cautioned taxpayers to use a more accurate valuation method to determine the taxable amounts under IRC 72 rather than the CSV (Announcement 88-51). Therefore, if a plan is distributing a "springing cash value" contract, it must value the contract using the total policy reserve value and not the stated CSV.
An employee can’t use the CSV to determine the amount to include in gross income under IRC 402(a) when the total policy reserves including life insurance reserves (if any) computed under IRC 807(d), plus any reserves for advance premiums, dividend accumulations, etc., more accurately approximate the fair market value of the policy (Notice 89-25, Question 10). If a plan inappropriately uses the CSV to value the amount distributed, thereby allowing a greater distribution than would otherwise be allowed, the distribution could be treated, in part, as an employer reversion. Also, in certain circumstances, these types of distributions could disqualify the plan (such as, distributions in excess of the IRC 415 limits).
If a plan is incorrectly valuing the contracts, obtain a corrected value using total policy reserve value instead. Refer any resulting adjustment to the participant's taxable income to EP Examinations per IRM 7.11.10, EP Examination and Fraud Referral Procedures.
Fully Insured Contract Plans
If Form 5310, line 7(e) is marked "Yes" or line 21(c)(12) shows 100 percent of assets invested in life insurance contracts, the plan is:
A fully insured contract plan.
Funded exclusively by purchasing individual insurance contracts.
Under these contracts, each participant receives level annual premium payments until normal retirement age. The plan benefits equal the benefits under each contract at plan's normal retirement age.
For all fully insured contract plans:
Review lines 17(c) and 17(f) to determine if the plan is distributing insurance contracts.
Ensure that all premium payments have been made timely.
Verify that no rights under the contract have a security interest at any time during the plan year.
Verify that no policy loans are outstanding at any time during the plan year.
Review the benefit formula to ensure that it is nondiscriminatory. All of the contracts must have a cash value based on the same terms (including interest and mortality assumptions) and the same conversion rights. See 26 CFR 1.401(a)(4)-(3)(b)(5) for rules for safe-harbor insurance contract plans.
Segregated Account IRC 414(k)
IRC 414(k) accounts combine funding features, for example, a DB feature and a DC feature.
Contributions going into the IRC 414(k) separate account are subject to the IRC 415(c)(1) allocation limits. Unlike a DB plan, there’s no limit on the amount the plan distributes.
The distributions coming from the DB plan are subject to the IRC 415(b)(1) distribution limit. Except for IRC 404 and IRC 412, there’s no limit on the amount an employer may contribute to the plan.
When a 414(k) plan establishes a separate account at normal retirement age, it’s considered an amendment that eliminates the DB feature of a participant's benefit under a DB plan and violates Section 411(d)(6) unless the plan meets the exception in 26 CFR 1.411(d)-4, Q&A 3. Therefore, review the plan’s separate account feature and determine if the transfer meets the following rules:
The transfer must be voluntary.
If the transferor plan is subject to the requirements of IRC 401(a)(11) and IRC 417, the plan must notify the participant and obtain spousal consent.
The participant whose benefits are transferred must be eligible, under the terms of the transferor plan, to receive an immediate distribution from that plan. If the employer is terminating the transferor plan, then they meet this requirement.
The amount of the benefit transferred must equal the participant’s entire nonforfeitable accrued benefit under the transferor plan subject to IRC 415 limits.
The participant must be fully vested in the transferred benefit in the transferee plan.
The participant must have the option of preserving his/her entire nonforfeitable accrued benefit, for example, as an immediate annuity contract which provides for all the benefits under the transferor plan if the plan is terminating, or by leaving the accrued benefit in the plan if it is ongoing.
The option to transfer benefits under the above rules constitutes an optional form of benefit under the plan per IRC 401(a). Accordingly, the transfer is subject to the:
Nondiscrimination provisions of IRC 401(a)(4).
Cash-out rules of IRC 411(a)(11).
Early termination provisions of IRC 411(d)(2).
QJSA requirements of IRC 401(a)(11) and IRC 417.
Transferring benefits from the DB to the 414(k) account isn’t a distribution for purposes of the minimum distribution requirements of IRC 401(a)(9).
The IRS doesn’t rule on a plan with a 414(k) separate account provision if it doesn’t meet the exception rules in paragraph IRM 18.104.22.168 (4) above. Request the plan sponsor to submit a written request to withdraw the application and return the case on Letter 1924 using procedures in IRM 22.214.171.124.1, Procedures When Not Authorized to Issue a DL.
If you determine that the 414(k) account violates IRC 411(d)(6), refer the case to EP Examinations per IRM 7.11.10, EP Examination and Fraud Referral Procedures.
Overfunded/Underfunded Plan at Termination
In the event of plan termination, assets in the trust after the satisfaction of the funding standards are allocated to participants under section 4044 of ERISA. This applies whether the plan is overfunded or underfunded. A review of the ERISA 4044 allocations determines whether an overfunded plan satisfies the nondiscrimination and reversion requirement. A review of the ERISA 4044 allocations or reallocations under an underfunded plan determines whether the available assets are allocated under the terms of the plan and the plan satisfies the nondiscrimination to the extent required by law. Review the Form 6088, Distributable Benefits From Employee Pension Benefit Plans, and Form 5310, line 21, to determine if the plan is overfunded or underfunded.
Section 4044(a) of Title IV of the Employee Retirement Income Security Act of 1974 (ERISA), Pub. L. 93-406, 1974-3 C.B. 1, sets forth the rules applicable to the allocation of assets to participants and beneficiaries by priority categories in the event of the termination of a defined benefit plan.
A Form 6088 is required for:
All DB plans.
Underfunded DC plans.
Each employer who has adopted a multiple employer plan.
Collectively bargained plans, only if: i) the plan benefits employees who aren’t collectively bargained employees or ii) more than 2% of the employees covered by the plan are professional.
Each employer employing employees in a multiemployer plan.
In the case where the assets equal liabilities, the specialist must determine why that is the case. In such case, a plan may have in its possession an agreement by one or more majority owners to forego their benefit, may have made promises to make the plan whole or may have completed the Form 6088 incorrectly. The instructions for the Form 6088 state "do not adjust for an election of a majority owner to forego receipt of a distribution under PBGC Regulations section 4041.21(b)(2)." The specialist should check for contributions receivable for any possible entry for promises to make the plan whole. The result of this determination must be documented on the Form 5621.
Differentiate between an election to forego a receipt and a waiver of benefit, the latter of which presents an impermissible assignment or alienation of benefit and is a qualification failure.
Overfunded Plan at Termination
If the sum of the value of benefit liabilities for all participants (Form 6088, column h) is less than the total assets (Form 5310, line 21), the plan is overfunded. If the assets equal the liabilities, work the case as an underfunded plan until facts are known.
The plan sponsor can correct overfunding in one or more of these ways:
Amend the plan to provide for increased benefits. See IRM 126.96.36.199.1.1 , Excess Assets Applied to Participants.
Recovery of surplus by the employer. See IRM 188.8.131.52.1.2 , Reversion of Excess Assets.
Establish a qualified replacement plan per IRC 4980(d). Follow the processing procedures in IRM 184.108.40.206.1.2 (5), Reversion of Excess Assets.
Plan sponsors may also attempt to recover surplus assets in a termination/reestablishment or spin-off/termination. They must follow the conditions in: "Implementation Guidelines for Termination of Defined Benefit Plans" , issued 5-24-84 Implementation Guidelines for Termination of Defined Benefit Plans and also in "Processing Employee Plan Cases that Terminate with Reversion of Surplus Assets" , issued 6-1-84. Processing Employee Plan Cases that Terminate with Reversion of Surplus Assets.
In the case of a so-called "spin-off/termination" , generally no termination will be recognized and any attempt to recover surplus assets will be treated as a diversion of assets for a purpose other than the exclusive benefit of employees and beneficiaries unless the following conditions are satisfied:
The benefits of all employees (including those covered by the ongoing plan) must be fully vested and nonforfeitable as of the date of termination.
All benefits accrued as of the date of termination in the ongoing plan must be provided for by the purchase of annuity contracts which represent irrevocable commitments for the benefit of each individual participant.
All employees who were covered by the original plan must be given advance notice of the transaction in similar time and manner as if the entire original plan were being terminated.
If the plan is overfunded, determine which methods the plan sponsor used to correct the overfunding, and ensure they applied it in a nondiscriminatory manner. Plans must use the methodology set out in Rev. Rul. 80-229 to avoid discrimination.
Excess Assets Applied to Participants
A plan that has assets in excess of plan liabilities (whether or not vested) may apply the excess assets to participants. Excess assets means that plan assets are more than sufficient to pay all benefits under the plan without either a majority owner using an agreement to forego receipt of benefits or other future promises. A majority owner may not forego his benefit to create a larger reversion because it violates the anti-alienation requirements of ERISA, Section 206(d)(1), and IRC 401(a)(13). Do not use this section for plans that have this type of agreement or condition.
The plan may apply the excess to increase the participants’ accrued benefit in a nondiscriminatory manner. Generally, plans without any permitted disparity or super-integrated plan formulas in their benefit formula are permitted to allocate excess plan assets based on the ratio of each participant’s PVAB to the PVAB of all plan participants without testing for nondiscrimination. If the current or past benefit formula either partially or fully used permitted disparity including super integrated formulas, the plan may need to run an IRC 401(l) test or general test. Rev. Rul. 80-229 contains rules and examples on nondiscriminatory allocation of excess assets.
The plan sponsor may only apply excess assets to participants if the plan already has a provision allowing it or they adopt an amendment or resolution for it. Review Form 5310, line 17(k) and the applicable plan provision or amendment to make sure that the plan reallocated excess assets in a nondiscriminatory manner. Verify no participant exceeded the IRC 415 limits when the plan reallocated excess assets.
Reversion of Excess Assets
If Form 5310, lines 5(c) and 17(i) indicate that the plan will have or has ever had a reversion, make sure that the reversion was permissible.
In general, no part of a qualified plan's trust may revert to the employer, but a reversion may occur under certain circumstances. See IRC 401(a)(2), 26 CFR 1.401-2, and ERISA 403.
For a multiemployer plan, reversions may occur by reason of mistakes in law or fact or return of any withdrawal liability payment.
For a plan other than a multiemployer plan, reversions may occur by reason of mistake of fact.
For overfunded DB plans, reversions are only permitted on plan termination if the plan has met all liabilities for the participants and their beneficiaries.
Don't close the case until you have proof that the reversion was due to erroneous actuarial computation and you reviewed the plan to ensure its terms allowed reversions for at least five calendar years preceding the plan’s proposed termination date. A surplus accumulated as a result of a change in the benefit provisions or in the eligibility requirements of a plan is not the result of an erroneous actuarial computation. 26 CFR 1.401-2(b)(1).
If the plan has not allowed reversions for at least five calendar years preceding the plan’s proposed termination date, excess plan assets must be applied to plan participants under existing plan provisions.
A plan may reduce the excess by making a direct transfer of assets to a qualified replacement plan, as described in IRC 4980(d), that was established or maintained by the Employer. See QA manager's email titled Reversion of excess assets in the "Terminations" folder in the "Worksheets" folder on the shared server. The qualified replacement plan must provide for the receipt and immediate allocation of excess assets in the form of a direct transfer from the terminating plan. The qualified replacement plan must provide for the allocation of the excess assets that will satisfy the requirements of IRC 401(a)(4) and IRC 415. Generally, the plan will provide for a suspense account for amounts in excess of 415 at the time of transfer. See Rev. Rul. 2003-85
Generally, plan participants aren’t entitled to excess assets unless the plan specifically allows it. Therefore, a plan could provide a direct transfer to a qualified plan or choose to allocate the excess assets to participants (as IRC 415 allows) in the event the reversion language is absent or not in existence long enough to allow a reversion. If the plan chooses to allocate excess assets, a plan termination amendment may be used to amend the plan for such pro-rata increase in benefits. Remember, excess assets are not part of the accrued benefits nor part of liabilities of the plan. Liabilities of the plan (including contingent liabilities) must be satisfied before excess assets can be used to increase benefits to reduce a surplus.
If review of the application determines that the sponsor plans to establish a qualified replacement plan in accordance with IRC 4980(d), the specialist should follow the processing procedures in paragraph IRM 220.127.116.11.1.2 (5) , below. While the applicant indicates the intent to transfer the amount, we will not have documentation prior to the closing of the case that this was actually done in operation; thus, the sponsor should be advised of the excise tax ramifications if the exception under IRC 4980(d) is not met. In such case, we assume a reversion could take place so prepare the case as if there will be a reversion.
If there is a possibility of a reversion, follow these procedures:
Use paragraphs 1, 3 and 33 on the 1132 letter. Print Form 15091, which can be found in the repository. Include the Form 15091 in the enclosures section of the letter.
Prepare a Form 5666, TE/GE Referral Information Report.
Refer the case to EP Examinations per IRM 7.11.10, EP Examination and Fraud Referral Procedures.
Discuss in your report whether the plan sponsor has both: included the reversion as income on its tax return and paid excise tax on it. See IRM 18.104.22.168.1.3 .
Send reversion cases exceeding $5,000,000 to QA using the TEDS mandatory review indicator process. Attach Form 3198-A, TE/GE Special Handling Notice, when you’re done with the case.
Government entities are exempt from these procedures. Tax exempt plans subject to ERISA will follow these procedures unless the plan is maintained by an employer that has, at all times, been exempt from tax under subtitle A. See IRC 4980(c)(1) (A) and (B).
In general, a plan sponsor may not attempt to receive a reversion in a termination/reestablishment or spin-off/termination earlier than 15 years following any previous similar transaction. If you've determined that a spin-off/termination or termination/reestablishment is not part of an integrated transaction in the Implementation Guidelines, request technical advice to resolve the case. See IRM 7.11.12, Preparing Technical Advice Requests.
Tax on Reversion
Taxable income to the plan sponsor in the year they receive it.
Taxed under the applicable federal tax rates.
Subject to an excise tax of 50% of the reversion amount under IRC 4980(d).
The 50% excise tax is reduced to 20% if the plan sponsor shows in writing that it meets one of the exceptions below:
The plan sponsor was in Chapter 7 bankruptcy liquidation (or similar proceeding under state law) on the date of plan termination.
The plan sponsor amended the plan before or at plan termination to provide immediate pro rata benefit increases (with a present value equal to at least 20% of the amount that would have otherwise reverted) to all qualifying participants. This 20% amount is determined, after all liabilities owed to participants are allocated under ERISA 4044, even if the plan already provides for allocation of excess assets upon plan termination.
The plan sponsor directly transferred at least 25% of the excess assets to a qualified replacement plan (as defined in IRC 4980(d)(2)) before any amount reverted to the plan sponsor. Also, at least 95% of active participants in the terminated plan must participate in the replacement plan to be considered a qualified replacement plan.
Any amount transferred to a qualified replacement plan isn’t, (i) included in the plan sponsor’s income, (ii) deducted by the plan sponsor, or (iii) treated as a reversion. Therefore, if the entire amount of a reversion is transferred to the qualified replacement plan, no income or excise tax would be due. (Rev. Rul. 2003-85)
Keep in mind that if the replacement plan is not a "qualified replacement plan" , a reduction in the excise tax is not applicable, nor is the treatment described in the preceding note.
If Form 5310, lines 5(c) and 17(i) show a reversion has taken place, verify the plan sponsor filed Form 5330 and paid the tax and excise tax (if applicable) on the reversion.
Underfunded DB Plan at Termination
If it is certain that the sum of the value of benefit liabilities (which includes unvested accrued benefits) of all participants (Form 6088, column h) is more than the total assets, or projected assets, (Form 5310, line 21 should reflect this amount), the plan is considered underfunded. Review the prior three years’ Form 5500, Schedule SB, to determine if there’s a funding deficiency. Any funding deficiency must be cured before considering whether the plan is underfunded.
For a plan that is subject to the PBGC, if the plan is underfunded, then the plan sponsor may generally terminate the plan under a standard termination. For a plan that is not subject to the PBGC, if the plan is underfunded, then the plan sponsor may choose to make the plan sufficient. In either case a plan may cure an underfunding by using one or a combination of the three following options (otherwise the plan will have to terminate under a distress (PBGC plan) or as an underfunded non-PBGC plan termination).
Make (or promise to make) a supplemental employer contribution (beyond the minimum funding requirement) to make the plan whole.
Allocate trust funds according to ERISA 4044.
A majority owner may forgo his or her distribution. Support this option, if chosen by a majority owner, by perfecting any noncompliant waiver document.
For a plan that is not subject to the PBGC, the terms standard and distress termination are not used. It’s either underfunded or it is sufficient.
For both PBGC and non-PBGC plans, the assets in a plan termination will be allocated under ERISA 4044 even if a majority owner foregoes all of their benefit to make the plan eligible to use a standard termination (for PBGC plans) or make a plan sufficient (for Non-PBGC plans).
If a plan is able to terminate as a "standard" termination or a "sufficient" termination because one or more majority owners forgoes receipt of payment, the plan must still allocate trust funds per ERISA 4044. For example, if the plan indicates that assets equal liabilities, the plan will still follow ERISA 4044 until it’s sure all assets are allocated or reallocated.
All plans subject to ERISA must allocate trust funds according to ERISA 4044, refer to Rev. Rul. 80-229 and Form 6088 instructions to ensure that allocations don’t violate IRC 401(a)(4). A plan doesn’t have to (although it may) specify ERISA 4044 allocation since this is a code requirement. ERISA Section 403(d)(1) (29 USC 1103(d)(1)) provides that ERISA plans that are not subject to PBGC must also allocate assets in accordance with ERISA 4044.
If one or more plan participant(s) is a majority owner (in other words, a participant with 50% or more interest in the employer), they may, with spousal consent, provide a statement agreeing to "forgo" receipt of all or part of their benefit until the plan satisfies the benefit liabilities of all other plan participants. An agreement that is not properly worded to forego receipt until all other plan liabilities are satisfied or fails to indicate spousal consent or that there is no spouse or is part of an amendment or resolution is a defective agreement. There may be other reasons it is a defective agreement such as not definitely determinable or does not protect the majority owner’s interest in the assets. Contact your actuary if you are uncertain. Keep in mind that for a plan that is not subject to the PBGC, the majority owner’s agreement to forgo receipt is never required and should be considered a gift to the other participants. So, treat it as a gift by fixing it rather than rescinding a defective agreement. In the case of a plan subject to the PBGC, the agreement may be necessary to terminate as a standard termination. However, it still benefits the non-highly compensated employees. In this case, it is still necessary to perfect rather than rescind a defective agreement.
This is not a "waiver" or forfeiture under IRC 411(a).
This doesn’t affect the plan's otherwise applicable minimum funding requirements in the year of termination.
See PBGC Reg. 4041.2 and 4041.21(b)(2) https://www.pbgc.gov/prac/laws-and-regulations/code-of-federal-regulations
Forgoing receipt of benefits cannot be accomplished under an amendment or resolution; otherwise it would violate the anti-cutback provisions of 411(d)(6).
If a plan accepts an agreement to allow a participant or spouse to waive accrued benefits, it violates the forfeiture rules in Section 411(a).
If a plan allows a participant or spouse to assign benefit to others in the plan, the plan violates the anti-assignment rules in 401(a)(13).
Plan assets allocated according to these priorities generally will be deemed nondiscriminatory:
Except as provided in d) below, the plan assets are allocated according to PBGC, ERISA 4044(a)(1), (2), (3), and (4)(A). PBGC has authority to approve this allocation. Allocations in these categories aren’t reallocated to avoid discrimination because they’re deemed nondiscriminatory.
If there are any assets left in ERISA section 4044(a)(4)(B), (5) and (6) categories, the assets may be required to be reallocated, to the extent possible, so that nonhighly compensated employees receive at least the same proportion of the PVAB of highly compensated employees within that category.
Despite any other paragraphs, the plan may reallocate assets restricted by 26 CFR 1.401(a)(4)-5 to the extent necessary to help satisfy b) above within each category.
For a plan establishing subclasses per ERISA 4044(b)(6), the plan may reallocate the assets described in any paragraph of ERISA 4044(a) within that paragraph to satisfy b) above.
If the plan sponsor hasn't satisfied the minimum funding standards or filed Form 5330, refer the case to EP Examinations per IRM 7.11.10, EP Examination and Fraud Referral Procedures.
Minimum Funding Standards
IRC 412 imposes minimum funding standards on certain types of plans to protect a participant's promised benefits. Plan sponsors are subject to a tax under IRC 4971 if they don't meet the funding standards.
IRC 412(a)(2) requires plan sponsors of a:
DB plan, which is not a multiemployer, to make contributions to (fund) the trust for the plan year of the required minimum contribution. (IRC 430).
Money purchase plan to fund the trust for the plan year in the amount required under the plan terms unless they have a funding waiver.
Multiemployer plan to fund the trust for the plan year in an amount so that the plan doesn’t have an accumulated funding deficiency. (IRC 431).
Multiemployer plans that fall into endangered or critical status have additional funding rules (added by PPA '06). (IRC 432).
A plan termination doesn’t relieve the plan sponsor of its obligation to fund the plan.
For a DB plan, the charges and credits are ratably adjusted for the part of the plan year before the proposed plan termination date.
For a money purchase plan, the minimum funding standard charges are any contributions due for participant-accruals earned on or before the proposed termination date, but not for contributions due after that date.
If a money purchase plan terminates before the last day of the plan year and has a "last day requirement" to earn an allocation, no contribution is required for that year. However, if a money purchase plan terminates in August and the plan requires a participant to work 1,000 hours of service to earn a benefit accrual and doesn’t have a last day requirement, the plan has a minimum funding obligation for participants who worked 1,000 hours or more.
Because the funding standard continues to be in effect until the end of a plan year in which a plan is properly terminated, carefully review the proposed termination date. (See IRM 22.214.171.124 , Proposed Date of Plan Termination.) The plan year is not automatically ended with the plan termination. See 26 CFR 1.401(a)(4)-12 and 26 CFR 1.410(b)-9.
These plans may continue to have funding obligations:
Plans that don’t distribute assets on the proposed date of termination or within a reasonable time.
Plans that haven’t given proper notice of termination to participants.
If you change a proposed date of termination for any reason, the minimum funding requirement (and participants’ accrued benefits) will likely have to be adjusted to reflect the new termination date. After you’ve determined the amount of the required contribution, review Form 5310, line 15 to ensure that the employer paid the correct amount.
IRC 4971(a) imposes a tax on plan sponsors who fail to make a required contribution to the plan by the funding due date. Verify that the contribution was paid within 8 1/2 months after the plan year end by reviewing Form 5310, line 15. You may need to secure proof of the contribution.
If the plan has a funding shortfall for the preceding year, the single employer must make contributions in four quarterly installments. (IRC 430(j)(3)).
If a single employer plan doesn’t make the required contribution within 8 1/2 months after the plan year end, the IRS imposes an excise tax of 10% of the aggregate unpaid minimum required contributions for all plan years. (IRC 430(j)(1)).
If a multiemployer plan doesn’t make the required contribution within 2 1/2 months after the plan year end (may be extended up to a total of 8 1/2 months), the IRS imposes an excise tax of 5% of the accumulated funding deficiency determined under IRC 431 as of the end of any plan year ending with or within the taxable year. (IRC 431(c)(8)).
For both single and multiemployer plans, if the plan sponsor doesn't correct the deficiency (reduce it to zero) by the end of the tax year in which the plan is terminated, the 100% penalty tax described in IRC 4971(b) may apply.
Use the table below to determine a single employer and multiemployer plan’s contribution due date for both funding and deductibility and the applicable tax for minimum funding, if paid late.
Review Form 5310, line 17(h)(2) to determine if a plan has an accumulated funding deficiency or aggregate unpaid minimum required contributions. If it does and the period for making timely contributions:
Is still open, make sure that the plan sponsor made the contributions for the final plan year.
Has expired, the plan sponsor must file Form 5330, Return of Excise Taxes Related to Employee Benefit Plans, for the amounts due, or you must make a referral on Form 5666, TE/GE Referral Information Report to the TE/GE Referral Group.
Some plans or a majority owner may attempt to correct an accumulated funding deficiency or aggregate unpaid minimum required contributions by waiving or by having plan participants "waive" their accrued benefits. These types of waivers violate IRC Sections: 401(a)(13) assignment and alienation, 411(a) minimum vesting standards and/or 411(d)(6) accrued benefit not to be decreased by amendment.
A majority owner may "forgo" receipt of their benefit. However, this still does not cure a funding deficiency nor unpaid aggregate minimum required contributions. See IRM 126.96.36.199.2 , Underfunded Plan at Termination.
A plan administrator may not change the plan's funding method in the year in which the plan terminates unless the plan administrator obtains approval for a change in funding method. See Rev. Proc. 2000-40, Section 4.02.
If the plan amortizes a funding waiver (under IRC 412(c)(3)) in the year in which it terminates, the plan sponsor must meet all obligations for the waiver as stated in the waiver ruling letter in the year of termination:
The plan sponsor is obligated to make all required amortization payments necessary for the waiver and payments for plan termination, if any, on which the approval of the waiver is contingent.
The plan can’t prorate a waiver amortization charge in the funding standard account in the year of termination. A plan sponsor maintaining a plan with an unamortized waiver may contribute and deduct an amount equal to the outstanding balance of the waiver in any year, including the year of termination.
The plan sponsor may not amend the plan in the year of termination to reduce or eliminate any contribution requirement for that year, unless either:
All employees’ accrued benefits are protected as of the later of the amendment’s adoption or effective date.
The plan satisfies the requirements of IRC 412(d)(2) allowing certain retroactive benefit reductions.
Discretionary plan amendments, adopted within the first 2½ months of the current plan year, that increase accrued benefits retroactively based on service during the immediately prior plan year under IRC 412(d)(2), don’t violate the discretionary amendment deadlines under Rev. Proc. 2016-37, Section 8.02 per the Memorandum from Robert S. Choi issued December 16, 2015.
A benefit is not considered "accrued" for this purpose unless a participant satisfies all conditions to accrue the benefit under the plan.
A DC plan requires that a participant earn an hour of service on the last day of the plan year to receive a contribution. A plan sponsor's amendment to reduce its contribution requirements doesn’t violate IRC 411(d)(6) if they adopt it before the last day of the plan year. (Rev. Rul. 76-250).
Adjusted Funding Target Attainment Percentage (AFTAP)
IRC 436, added by PPA '06, adds protections and restrictions to the participant's benefits in single and multiple employer DB plans. In addition, the plan may need a required amendment to comply with the Highway Transportation and Funding Act of 2014, Section 2003. P. L. 113-159.
IRC 436 doesn’t apply to multiemployer or DC plans.
For a single employer DB plan, request:
Schedule SBs for plan year that contains the termination date and the two prior plan years.
All AFTAP certifications for year of termination and two prior plan years. Also, request any interim AFTAPs and range certifications.
Any 101(j) notices the plan sponsor provided in the year of termination and two prior years.
If a single employer DB plan is underfunded for any plan years beginning after December 31, 2007, there could be possible restrictions on:
Unpredictable contingent event benefits under IRC 436(b)(3).
Plan amendments increasing liability for benefits under IRC 436(c).
Accelerated benefit distributions under IRC 436(d).
Benefit accruals for plans with severe funding shortfalls under IRC 436(e).
This chart is a quick guide to the AFTAP restrictions. See IRC 436 for further explanation on the restrictions.
Interested Party Notices Upon Plan Termination
The plan sponsor must notify interested parties of their plans to file an application request to terminate the plan 10 - 24 days before they send it to the IRS. See Rev. Proc. 2022-4, Section 20.02 (updated annually).
Review Form 5310, line 8 and the copy of the "Notice to Interested Parties" to ensure that notice was provided 10–24 days before the application’s control date.
If the application is received without the notice, request a copy.
If the plan sponsor didn’t give the notice timely, return the application incomplete using a Letter 1924. Use paragraph 1 with a variable. "Rev. Proc. 2022-4, Section 10.12 (updated annually)" , and request a copy of the notice.
PBGC Notice on Plan Termination
Plans not exempt from the PBGC requirements under ERISA 4021(c) must file either of these forms with the PBGC for their proposed termination:
Form 500, Standard Termination Notice Single Employer Plan Termination
Form 601, Distress Termination Notice Single Employer Plan Termination
Also, the plan sponsor must give advance notice to all affected participants 60 - 90 days before the proposed termination date. This notice is in addition to the Interested Party Notice in IRM 188.8.131.52 .
If the plan sponsor doesn't file the required form or give notice to affected participants, PBGC may reject the proposed termination date. When this happens, PBGC notifies:
The plan sponsor that a termination has not occurred and that it must begin the termination process again.
The IRS to check for any open Form 5310 applications for the plan sponsor.
If PBGC rejects a proposed termination date on an open application, stop all work and return the case to the plan sponsor with the full user fee refund (if applicable). The plan sponsor may submit a new application with a corrected proposed termination date, if they wish.
If you don’t have the Form 5310 in your inventory or if you've already issued a DL, no action is necessary.
More Internal Revenue Manual
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How to Give Stock as a Gift (And Why Tax Pros Like The Idea)
Many or all of the products featured here are from our partners who compensate us. This influences which products we write about and where and how the product appears on a page. However, this does not influence our evaluations. Our opinions are our own. Here is a list of our partners and here's how we make money .
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Gifting stocks may be a way to both give and avoid paying capital gains taxes.
Instead of donating cash, investors can donate stock to charities.
Investors can donate stock to their kids through custodial accounts.
Stock can be gifted to friends and family as a way of building wealth.
What's a gift that's more thoughtful than a stack of cash, doesn't require leaving the house and keeps on giving longer than a jelly-of-the-month club membership? Stock.
This year may be an ideal year to gift stock, considering ongoing supply chain delays. This means the gifts you'd like to buy may not be on shelves, and even if they are, inflation could be making them too pricey anyway.
Gifting stock is easier than you think, and doing so may offer a few perks for you, too.
The benefits of gifting stocks
Hang around seasoned investors long enough, and you’ll likely hear a familiar refrain: If only I’d started investing sooner. Giving stocks as a gift can help your family and friends put this advice into practice — especially kids, who may benefit most from long-term compounding returns.
And if you’re giving stocks you already own, there could be a tax advantage for you. From a tax perspective, gifting is a smart way to transfer an appreciated stock, says Karl Schwartz, a certified public accountant and principal at Team Hewins in Boca Raton, Florida.
"Let’s say you’re an adult and you have this stock with a lot of gains built into it. If you were to sell it, you would pay taxes on the gain. Assuming it’s long-term, you might pay 15%," he says. But instead of selling the stock, you could give it as a gift, transferring the gains to the recipient.
"The person who received the stock now has that appreciated stock. They can hold it if they want, but if they sell it, assuming they’re in a lower tax bracket, they might pay 0% in capital gains taxes," Schwartz says.
In other words, both the giver and receiver could avoid paying capital gains altogether on stock that’s been appreciating for years. (Learn more about how capital gains taxes work.)
That’s not the only route to giving stocks, though. You can also buy stocks or other securities you don’t already own, then gift them. Here are two reasons you might consider gifting stocks this year.
1. To give to charity the wise way
As long as the charity is set up for it, donating stock instead of cash can be a smart way to do good this holiday season.
For example, if you want to donate $1,000 to a charity but have to dip into your portfolio to raise the cash, you might pay capital gains taxes on that sale, netting you less than $1,000 to donate. But if you gave $1,000 in stock instead, there’s no tax consequence for you because you’re not realizing any of the gains, and the charity won’t pay taxes when it sells the stock since it's a tax-exempt entity. What’s more, you may be able to claim a fair market value charitable deduction on that donation. Want to pass these savings back to the charity? All the merrier.
» Learn about more charitable giving tax strategies .
2. As an early step toward passing down wealth
If you’re thinking about your legacy, gifting stocks can be a valuable tool, as opposed to liquidating and paying capital gains taxes. As of 2022, the IRS allows you to gift up to $16,000 per year, per person — including stock. In 2023, that number increases to $17,000. Married individuals who file jointly can gift up to $16,000 each in 2022 and $17,00 in 2023, for a total of $32,000 or $34,000 to any single recipient.
This $16,000 limit in 2022 isn't bound by familial or marital ties. So technically, you could give $16,000 in stock to all of your children, grandchildren, in-laws, friends and neighbors each year. Couples who file jointly may also be able to take advantage of gift splitting by filing Form 709, which allows them to utilize the doubled gift limit even if only one spouse is contributing.  Internal Revenue Service . Instructions for Form 709 (2021) . Accessed Sep 8, 2022. View all sources
» Learn more about gift taxes or estate planning .
How to gift stock
There are a few different ways to gift stock, and the best way depends on the age of the recipient. You can gift stock to kids through a custodial account, while you can gift stock to adults through a simple transfer.
1. Gifting stock to kids through a custodial account
One of the simplest ways to get kids started in stocks is to set up a custodial brokerage account . You’ll be able to transfer existing shares of stock, mutual funds or other securities from your account to the custodial account, or buy specific securities directly within the custodial account. The child will take control of the account when they hit a certain age — typically 18 or 21, depending on the state.
Be wary of what the IRS calls the "kiddie tax," though. Once a child's unearned income hits $2,300, it can become taxable at the parent's tax rate .  Internal Revenue Service . Topic No. 553: Tax on a Child's Investment and Other Unearned Income (Kiddie Tax) . Accessed Sep 8, 2022. View all sources For this reason, it may be favorable to select stocks that pay out little to no capital gains or interest.
If you're considering a custodial account for a child, it's also worth exploring Roth IRAs for kids . You can't transfer stocks as a gift like you can with a custodial account, and the child will need to have earned income to get started, but it's one way to avoid the kiddie tax issue (and the account grows tax-free).
2. Gifting stock to friends and family
All that’s required to transfer shares to an adult friend or family member is for the receiver to have a brokerage account . There are a few logistical hurdles — you’ll need their account information and a few more personal details to actually perform the transfer — but if a promissory message in a Christmas card is sufficiently exciting, gift away. If they don’t have an account, you could help open and fund one for them as part of the gift.
You can start the process online in your own brokerage account by opting to gift shares or securities you own; if you can’t find that option, contact your brokerage firm directly. If you want to gift a stock you don’t already own, you’ll have to purchase it in your account, then transfer it to the recipient.
On a similar note...
26 U.S. Code § 1041 - Transfers of property between spouses or incident to divorce
Subsection (a) shall not apply if the spouse (or former spouse) of the individual making the transfer is a nonresident alien.
1988—Subsec. (d). Pub. L. 100–647 substituted “Subsection (a)” for “Paragraph (1) of subsection (a)” and “the spouse (or former spouse)” for “the spouse”.
1986—Subsec. (e). Pub. L. 99–514 added subsec. (e).
Pub. L. 100–647, title I, § 1018 (l)(3), Nov. 10, 1988 , 102 Stat. 3584 , provided that the amendment made by that section is effective with respect to transfers after June 21, 1988 .
Amendment by Pub. L. 99–514 effective, except as otherwise provided, as if included in the provisions of the Tax Reform Act of 1984 , Pub. L. 98–369, div. A , to which such amendment relates, see section 1881 of Pub. L. 99–514 , set out as a note under section 48 of this title .
Pub. L. 98–369, div. A, title IV, § 421(d) , July 18, 1984 , 98 Stat. 795 , provided that:
For provisions directing that if any amendments made by subtitle A or subtitle C of title XI [§§ 1101–1147 and 1171–1177 ] or title XVIII [§§ 1800–1899A] of Pub. L. 99–514 require an amendment to any plan, such plan amendment shall not be required to be made before the first plan year beginning on or after Jan. 1, 1989 , see section 1140 of Pub. L. 99–514 , as amended, set out as a note under section 401 of this title .
More From Forbes
The 4 pitfalls of ‘designated beneficiaries’ on transfer on death investment accounts.
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Please be aware of the pitfalls of using a TOD transfer on death beneficiary designation. (Photo ... [+] credit should read STR/AFP via Getty Images)
When you set up an account to "transfer on death," the assets will go directly to beneficiaries upon the owner's death. While these assignments can help avoid probate , this account titling should still be carefully coordinated with the owner's overall estate plan, especially for larger accounts and estates.
While simply titling an account "Transfer on Death" and adding a beneficiary or two may seem common sense, it may not always be so simple. This type of account can easily be set up on most investment accounts. The main benefit to these types of accounts is that assets can be transferred relatively quickly to a beneficiary, and the costly and timely process of probating the assets is avoided. Another advantage is beneficiaries can be changed more easily than amending a trust, for example.
As they say, there is no free lunch. Titling an account "transfer on death" will not solve all your estate planning needs. Likewise, mistakes or omissions can be made with any beneficiary designations. Here are a few of the issues you need to be aware of when using a Transfer on Death (TOD) account titling.
A new marriage should prompt you to review you beneficiaries. NEW ORLEANS, LA - NOVEMBER 16: Jay Z ... [+] (L) and Beyonce Knowles attend the secondline following sister Solange Knowles and her new husband, music video director Alan Ferguson's wedding on the streets of New Orleans on November 16, 2014 in New Orleans, Louisiana. (Photo by Josh Brasted/WireImage)
Life Changes Need to Be Addressed
Titling of the accounts won't change when your life does. Marriage, divorce, death of a beneficiary all should prompt you to review your beneficiaries. Make sure you decide who you want to inherit your IRAs and 401(k) as well.
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How to fund a trust with life insurance, ignoring your overall estate plan.
Your TOD accounts need to be coordinated with your overall estate plan. The importance of this grows with the size of your net worth. Failing to keep beneficiaries' updates can lead to strife among your heirs and might even lead to litigation. Picture setting up a TOD account with equal balances for each of your three children (just as an example). Well, 20 years go by, and between withdrawal and varying account performance, each of the three accounts has a vastly different account balance. If this was not your intent, some adjustments to beneficiaries might be needed. Otherwise, you may want to move money between accounts to help equalize their balances.
Another issue that pops up when most of your assets are held TOD, once the account is passed to the beneficiary, the estate may not have enough money left to pay taxes or maintain the family etc. There is less flexibility on the estate planning side with a TOD account when compared with a living trust.
Be careful when naming a minor as your beneficiary on your Transfer on Death account. Typically, investment firms will not release the assets of an account to a minor without a court order naming which adults have the legal authority to make a financial decision on behalf of the minor. Also, the TOD assignment doesn't allow for any instruction on how money is to be used. You also can't restrict it until a certain age like you can with a trust. What could go wrong with giving an 18-year-old unfettered access to a large inheritance?
It is common for a married couple to create joint transfer-on-death accounts. (Often titled Joint Tenants with Rights of Survivorship JTWROS). Keep in mind that when one spouse dies, the other will receive complete control of the account under the right of survivorship. This can be a problem with blended families, or marriages, later in life.
TOD accounts can cause issue when it comes to Elder Care. LOS ANGELES, CA - APRIL 20: Actresses ... [+] Betty White (L) and Cloris Leachman attend the 24th Annual GLAAD Media Awards at JW Marriott Los Angeles at L.A. LIVE on April 20, 2013 in Los Angeles, California. (Photo by Kevin Winter/Getty Images for GLAAD)
TOD for Elder Care?
As we age, we may need more help from a loved one. Many seniors have a Power of Attorney" (POA) who can help make decisions and pay bills on their behalf. TOD does not give anyone power of attorney.
Set a calendar reminder to check your beneficiaries every year or two. You'd be amazed at how often a child is missed, or your life savings are being left to your first husband (whom you now hate). There may be reasons for these omissions, or perhaps, you just never updated your beneficiary on an account set up decades ago.
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Intm440030 - transfer pricing: types of transactions: transfer of trading stock, transfer of stock: transfer pricing rules.
In most trades, where different companies are involved in the chain of manufacture, distribution, retailing, etc, of product, stock is routinely sold from one company to another at each stage of manufacture or development. In some such cases normal accountancy practice may be that the transfers occur at the open market value. This value will also generally apply for tax purposes. Extending transfer pricing rules to domestic transactions is unlikely to have a significant impact in these cases.
But there are some situations where tax rules and accounting practices diverge. Firstly, there is the situation where one company ceases to carry on a trade, and transfers its trading stock to a related party which intends to carry on that trade, either as a new trade, or as an extension to its own existing trade. Secondly, normal accountancy practice may permit stock to be valued at the lower of cost or net realisable value (see BIM33115 ).
The common feature of such situations is that accounting rules permit the transfer of stock to take place at the ‘book value’ rather than the open market value where the latter would be a higher figure.
Until the introduction of transfer pricing rules applicable to wholly domestic transactions, the tax rules applying to the treatment of trading stock on the cessation of a trade were dealt with in ICTA88/S100, now re-written as CTA09/S162 onwards. There is an arm’s length rule at CTA09/S166 where the parties are connected, but with the capability to elect in S167 for a lower value where the price actually paid and the original acquisition value are both less than the arm’s length price. For tax purposes the higher of these two alternative values is utilised.
Where CTA09/S162 onwards is not in point, because there is no cessation of trade by a company, then, apart from the transfer pricing rules, tax will follow generally accepted accounting practice. This would permit the transfer to be recorded at the actual price paid for the stock, rather than requiring an arm’s length or market value to be used.
In the first type of case outlined, the extension of the transfer pricing rules to such situations and the disapplication of the valuation rules by CTA09/S162(2) would, absent any other provision, prevent connected parties to whom the disapplication applies from obtaining the same benefits as connected parties to whom the disapplication does not apply can receive from an election under CTA09/S167. In the other cases, the application of the transfer pricing rules would, where the book value of stock was less than the arm’s length price, recognise a profit for tax purposes that had not yet been realised by the group. This is because the timing of the taxation of an adjustment to the profits of the transferor would not necessarily be matched by the effect of the compensating adjustment that the transferee would be entitled to claim under TIOPA10/S174.
TIOPA10/S174(2)(a) requires the disadvantaged party to recompute their profit as if the arm’s length provision had applied. Thus the uplift in the profit of the transferor would be matched by an increase in the purchase price of the stock held by the transferee. However, where that stock is still held at the end of the transferee’s accounting period, the compensating adjustment will also increase the credit made to the profit and loss account in respect of the value of trading stock carried forward. So there is no net reduction in taxable profits from the compensating adjustment until the stock in question is sold, resulting in accelerated taxation of profits.
TIOPA10/S174(4) and S180 addresses the majority of these situations. After first applying the transfer pricing rules to the transferor company, it permits a compensating adjustment that is effective to the transferee where the stock is still held at the end of the accounting period in which the transfer takes place. This is achieved by not including the value of the transfer pricing adjustment in the closing value of transferred stock for tax purposes.
The rule in TIOPA10/S180(2) ensures that the deduction available to the transferee cannot be taken before the transferor is taxed on the uplift in its profits, for example because of mismatched accounting periods.
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TAX ISSUES WHEN DIVIDING PROPERTY INCIDENT TO DIVORCE
Tax-free transfers incident to divorce, general rule, meaning of “incident to divorce”.
Section 1041 applies to all transfers between spouses and also to transfers between former spouses, to the extent made incident to divorce between the former spouses. (IRC § 1041, subd (a).) A transfer of property is “incident to the divorce” if the transfer (1) occurs within one year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage. (IRC § 1041, subd (c).)
Treasury Regulation 1.1041-IT(b) states that a transfer is “related to” the cessation of the marriage when the transfer is required under the divorce or separation instrument, and the transfer takes place within six years from the date of the divorce.”
If the transfer is not made pursuant to a divorce or separation instrument, or occurs more than six years after cessation of the marriage, it is presumed to be unrelated to cessation of the marriage. (Treas. Regs. § 1.1041-1T, A-7; see Ltr.Rul. 9306015.) The presumption may be rebutted “only by showing that the transfer was made to effect the division of property owned by the former spouses” at the time their marriage ceased. (Regs. § 1.1041-1T, A-7.)
“For example, the presumption may be rebutted by showing that (a) the transfer was not made within the one-and six-year periods described above because of factors which hampered an earlier transfer of the property, such as legal or business impediments to transfer or disputes concerning the value of the property owned at the time of the cessation of the marriage, and (b) the transfer is effected promptly after the impediment to transfer is removed.” (Id.)
In Private Letter Ruling 9235026 (May 29, 1992), the IRS ruled that the six-year presumption was overcome when the transfer of the Wife’s interest in business property to her ex-husband was incident to divorce even though the transfer occurred more than six years after the divorce. The IRS found that the transfer was delayed because of a dispute over the purchase price and payments terms, and that the transfer was effected promptly after the dispute was resolved. The IRS noted that Temp. Treas. Reg. §1.1041-1T, A-7 specifically provides that the presumption may be rebutted if factors such as “disputes concerning the value of the property” to be transferred prevented an earlier transfer.
Transfer to Non-Resident Alien Spouse
When the spouse who receives property incident to divorce is a nonresident alien, taxable gain will be recognized on the transfer. (IRC §1041, subd. (d).) The spouse making the transferor will be taxed on the gain (the difference between the fair market value of the property transferred and his or her adjusted tax basis in the property). The rationale for treating nonresident aliens differently is that the IRS assumes that it will eventually receive taxes on any gain realized when a spouse who receives property incident to divorce sells the property, since the spouse takes the transferor’s basis in the property; however, in the case of a nonresident alien, there may be little chance that the gain is ever reported or that tax will be paid.
Assignment of Income Doctrine
Income is ordinarily taxed to the person who earns it; one vested with the right to receive income cannot escape taxes by an assignment of the right to receive that income to another. (Lucas v. Earl (1930) 281 U.S. 111 (1930); Harrison v. Schaffner, 312 U.S. 579, 580; IRS Regulations, § 1.454-1(a).) Under the assignment of income doctrine, the transferor remains obligated to pay taxes on the accrued income he or she has assigned.
The assignment of income doctrine applies when the right to receive the income has already accrued, and the parties assign that right to the spouse who did not earn the income. For example, in a transfer of Series E or EE United States Savings Bonds to a spouse or former spouse, the transferor must include the accrued interest on the bonds in his or her gross income in the year of the transfer. (Rev. Rul. 87-112.) IRC § 1041 cannot be used to avoid recognition of the gain by transferring the right to receive the income already earned.
However, when an income-producing asset is transferred, the right to receive future income is transferred along with the underlying asset, such that the spouse receiving the asset is responsible for paying taxes on that income. For example, if a spouse is awarded an apartment building in a divorce, the spouse receiving the building will not recognize any gain on the transfer and will be responsible for reporting the rental income on his or her tax return.
On the other hand, if the parties make an agreement that one spouse will be solely responsible for paying taxes on the past rental income from the building (when it was held as marital property), the assignment of income doctrine will override that contractual allocation and require both parties to report the taxes.
Another example is where Wife agrees to pay Husband 40% of her bonus income as taxable spousal support. When Wife receives the bonus, she will have to report 100% of it as taxable wages, however she gets a deduction for the portion she pays to Husband as alimony. Revenue Ruling 2002-22 held that a taxpayer who transfers interests in nonstatutory stock options and nonqualified deferred compensation to the taxpayer’s former spouse incident to divorce is not required to include an amount in gross income upon the transfer.
The ruling also concludes that the former spouse, rather than the taxpayer, is required to include an amount in gross income when the former spouse exercises the stock options or when the deferred compensation is paid or made available to the former spouse.
The ruling states: . . . applying the assignment of income doctrine in divorce cases to tax the transferor spouse when the transferee spouse ultimately receives income from the property transferred in the divorce would frustrate the purpose of § 1041 with respect to divorcing spouses. That tax treatment would impose substantial burdens on marital property settlements involving such property and thwart the purpose of allowing divorcing spouses to sever their ownership interests in property with as little tax intrusion as possible.
Further, there is no indication that Congress intended § 1041 to alter the principle established in the pre-1041 cases such as Meisner [v. United States, 133 F.3d 654 (8th Cir. 1998] that the application of the assignment of income doctrine generally is inappropriate in the context of divorce.(Rev. Ruling 2002-22, see also Rev. Ruling 2004-60 (FICA taxes are deducted from the payment is made to the non-employee spouse).)
Interest on Equalizing Payments
If a spouse is required to pay interest to the other spouse regarding an equalizing payment, the interest will be treated as income to the spouse who received it. The spouse who pays the interest can take a deduction for those payments only if the debt was incurred to buy-out the other spouses interest in business or investment property. (See Armacost v. C.I.R. (1998) TC Memo 1998-150.)
The court in Armacost held Interest on indebtedness must be allocated in the same manner as its underlying debt. [Citation.] Underlying debt is allocated by tracing specific disbursements of the proceeds to specific expenditures. If the underlying debt is incurred as a personal expenditure, the interest on that debt may not be deducted under section 163 except to the extent such interest is qualified residence interest.
[Citations.] But if the underlying debt is incurred to acquire investment property, the interest on that debt is deductible under section 163 as investment interest. [Int.Rev. Code §163 (h)(2)(B).] Investment interest is defined as any interest paid on indebtedness properly allocable to investment property. Section 163(d).
Investment property includes property producing gross income from interest, dividends, annuities or royalties not derived in the taxpayer’s trade or business, or property held in the course of the taxpayer’s trade or business which is neither a passive activity nor an activity in which the taxpayer materially participates. Section 163(d)(5)(A), 469(e)(1).
State Law May be Different
Section 1041 applies only to taxes under federal law. The transfer could still be taxable under state law.
CONSIDERING TAX BASIS WHEN DIVIDING PROPERTY
Community property laws require the court to divide the community estate “equally” unless required otherwise by law or absent the written agreement of the parties. (See, e.g., Cal. Fam. Code, § 2550.) If tax consequences are not considered when dividing assets, the ultimate division is often far from being equal.
It is the attorney’s role to investigate the tax implications of the proposed division and to advise the client accordingly. In particular, the difference between the fair market value of an asset and its tax basis must be taken into account when evaluating whether there is an “equal” division of the marital estate. In negotiating settlements, the parties are free to discount property based on built-in tax liability associated with an asset.
Family courts at least in California, on the other hand, have been reluctant to take tax effects into account except when it is clear that the party will suffer immediate tax consequences from an expected sale of the property or from the transfer itself. An often-cited case in this area is In re Marriage of Fonstein (1976) 17 Cal.3d 738 where the California Supreme Court held :
“Regardless of the certainty that the tax liability will be incurred if in the future an asset is sold, liquidated or otherwise reduced to cash, the trial court is not required to speculate on or consider such tax consequences in the absence of proof that a taxable event has occurred during the marriage or will occur in connection with the division of the community property.” (Id. at p. 749, fn. 5.)
In Fonstein, the trial court assigned husband’s minority interest in a law partnership to him in a marital dissolution action after discounting its value for future tax consequences when sold. Under the partnership agreement, the husband had the right to withdraw from the partnership voluntarily and would receive a sum of money based on a formula set forth in the agreement. Although the husband had no intention of withdrawing from the partnership, the trial court discounted the value of the partnership interest by the taxes he would have to pay if he later decided to withdraw.
The California Supreme Court phrased the issue before it in the following terms:”In valuing Harold’s interest in the law partnership on the basis of his contractual right to withdraw from the firm, did the trial court err by taking into account the tax consequences which he might incur if he did withdraw at some later time, and by reducing the value of his interest accordingly, even though Harold was not withdrawing and had no intention to withdraw?”(Id. at p. 747 (emphasis added).)
The court answered the question as follows:”…[S]ince there is no indication in the record that Harold is withdrawing, must withdraw, or intends to withdraw from his firm in order to obtain the cash with which to pay Sarane her share of the community property, there is no equitable reason for allocating to Sarane a portion of the tax liability which may be incurred if and when he does withdraw. [Citation.]
In short, …, although Harold conceivably may do a number of things concerning his law partnership which may create tax consequences, ‘there is no indication that he must or intends to do’ any of them.” (Id. at p. 750.)In making its ruling, the court referred to the “immediate and specific tax liability” language it used in its earlier decision in Weinberg v. Weinberg (1967) 67 Cal.2d 557. (Fonstein, 17 Cal.3d at p. 749, fn. 5.)
This remains the rule in California, however when property is ordered sold and the proceeds divided, the court must take income taxes on the sale into account. (See In re Marriage of Epstein (1979) 24 Cal.3d 76.) In Epstein, the trial court ordered the family residence sold and the proceeds divided between the parties in such a manner as to equalize the division of the community property.
Since husband received personal property of substantially greater value than that awarded wife, she was due to receive the larger share of the proceeds from the sale of the house. The trial court’s order, however, did not mention the possibility that the parties might incur state and federal capital gains tax liability as a result of the sale of the residence. The wife appealed, arguing that the trial court erred by not expressly considering tax liability in its order.
The California Supreme Court agreed with wife that the court’s division of community property should take account of any taxes actually paid as a result of the court-ordered sale of the residence. The court explained: “Unlike Fonstein, which involved a speculative future tax liability arising on the hypothetical sale of an asset, in the present case the taxable event, the sale of the residence, occurs as a result of the enforcement of the court’s order dividing the community property.” (Epstein (1979) 24 Cal.3d at p. 88.)
Exclusion of Gain on Sale of Residence
In calculating gain on the sale of a principal residence, Internal Revenue Code section 121 provides that a taxpayer can exclude up to $250,000 of gain from the sale of principal residence if filing a separate tax return, or up to $500,000 for a joint return, if the following requirements are met:
- During the 5-year period ending on the date of the sale or exchange, the residence must have been owned by either spouse and used by both spouses as their principal residence for periods aggregating 2 years or more.
- An individual shall be treated as using property as such individual’s principal residence during any period of ownership while such individual’s spouse or former spouse is granted use of the property under a divorce or separation instrument.
- If a residence is transferred to a taxpayer incident to a dissolution of marriage, the time the taxpayer’s spouse or former spouse owned the residence is added to the taxpayer’s period of ownership.
- The exclusion can only be applied to one residence every two years, excluding pre-May 7, 1997 sales. (Treas. Regs. § 1.121-2; California has passed conforming legislation, Cal. Rev. & Tax. Code §17152.)
- (Treas. Regs. § 1.121-2; California has passed conforming legislation, Cal. Rev. & Tax. Code §17152.)
Need for Records
Temporary Regulations provide that “a transferor of property under §1041 must, at the time of the transfer, supply the transferee with records sufficient to determine the adjusted basis and holding period of the property as of the date of the transfer…. Such records must be preserved and kept accessible by the transferee.” (Temp. Treas. Reg. § 1.1041-1T, A-14.)
The judgment should specifically require the exchange of this information.
The right to deduct losses associated with an asset may be transferred together with the asset which generated the loss, or may be personal to the taxpayer and not subject to transfer, depending on the type of asset transferred. This is a complicated area because the loss carryforward was typically reported on a joint tax return during marriage and then, after the divorce, it may have to allocated between the parties for their separate returns. Still, the effort may be worthwhile due to the value of these carryforwards.
Net Operating Losses
A net operating loss from the operation of a business may be carried back to the prior two years (by amending the tax returns for the prior years) or carried over to the succeeding 20 years as a net operating loss deduction. (IRC § 172.) If the spouses filed a joint tax return for each year involved in figuring NOL carrybacks and carryforwards, the NOL is treated as a joint NOL. (IRS Publ. 536, p. 10.) Each spouse may carryover to his or her separate return his or her share of the joint NOL. (Huckle v. Commissioner, T.C. Memo 1968-45.)
Capital Loss Carry Forwards
For individuals, losses from the sales or exchanges of capital assets are allowed only to the extent of gains from such sales or exchanges plus up to $3,000 of ordinary income ($1,500 if the return is married, filing separate). (IRC § 1211, subd. (b).) Any capital loss that could not be deducted in one year may be carried over for an unlimited time until fully used up. (Id.)
If separate returns are filed after a net loss was reported on a joint return, the carryover is allocated to each taxpayer based on their individual net long-term and short-term capital losses for the preceding taxable year. (IRC § 1212, subd. (b)(1); Treas. Reg. 1.1212-1(c).) If incurred in a community activity, the losses are split equally on separate returns. Therefore, each spouse may carry forward his or her half of the loss to postdissolution income. (See Regs. § 1.172-7; Rose v. Commr., TC Memo. 1973-207.)
Suspended Passive Activity Losses
A passive activity is generally any trade or business in which the taxpayer does not materially participate, including rental activity whether or not there is material participation (subject to special rules for real estate rental activities and real estate professionals). (IRC § 469.) As a general rule, losses from passive activities may only be deducted from income from passive activities, and not against other types of income such as wages, interest or dividends. (Id.)
If a passive activity loss exceeds passive activity income for the year, the loss is “suspended” indefinitely as a deduction from passive activity income in the next succeeding tax years. (Id.)
If the asset which generates the passive activity loss is divided in-kind, the suspended passive activity loss is divided equally between the parties along with the underlying asset. On the other hand, if the passive asset is transferred entirely to one spouse and there is a suspended passive loss associated with that asset, the transferor cannot deduct the accumulated loss but the transferee’s basis increases by the amount of the unused suspended loss pursuant to IRC § 469(j)(6)(A). (IRS Publ. 504, p. 19; IRS Publ. 925; but see Pvt. Ltr. Ruling, Tech. Adv. Mem. 9552001 (dealing with S corporations).)
Suspended Loss Carryforwards re Subchapter S Corporations
In a Subchapter S corporation, the taxable income or loss is passed-through to the shareholders. (IRC § 1366.) Losses which exceed the shareholder’s basis in stock and debt in the corporation are suspended and carried forward to the succeeding tax years. (IRC § 1366, subd. (d)(1) (aggregate amount of losses and deductions taken into account by a shareholder for any taxable year shall not exceed the sum of the adjusted basis of the shareholder’s stock in the S corporation and the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder).)
When the stock in such a corporation is owned as community property and transferred or divided incident to divorce, the suspended loss carryforwards associated with the stock are transferred along with the stock on a pro rata basis based on the number of shares owned by each spouse during the tax year. (See IRC § 1367.) In an inkind division of the stock which was equally owned by the parties during marriage, each spouse will receive one-half of the suspended loss carryforward.
However, if the stock is awarded entirely to one spouse, the other spouse’s share of the suspended loss carryforward is not transferred to the other spouse. The carryforward is personal (having already passed-through to that spouse’s tax return when the loss was realized). (IRC § 1366, subd. (d)(2).)
The party receiving the stock will only have the benefit of his or her one-half share of the carryforward; the other half will be lost. It is not added to the basis in the stock, as the loss was disallowed in the year in which it occurred and carried forward. (Pvt. Ltr. Ruling, Tech. Adv. Mem. 9552001.) The spouse receives the transferor’s basis in the stock per IRC § 1041, which does not include the loss carryforward associated with the transferee’s stock. (See Taft, Tax Aspects of Divorce and Separation, § 5B.03[b].)
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By: Mark Vogel
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Tax-Free Transfers Incident to a Divorce – What Qualifies?
Dividing assets in a divorce is rarely a simple matter. It gets even more complicated when there is a transfer of property between spouses after a divorce.I
When transferring assets as part of a negotiated settlement or divorce proceeding, it might not be possible to complete the transfer immediately due to financial or logistical reasons.
Timing is everything , as the saying goes.
It’s important to understand the rules regarding the transfer of property between spouses after a divorce, and how the timing impacts how – and whether – transactions are taxed.
Does the Transaction Qualify As a Section 1041 Transfer?
A good starting point is to determine whether the transaction qualifies as an IRC Section 1041 transfer.
Internal Revenue Code Section 1041 lays out the rules for property that is transferred between spouses who are divorcing or are divorced. It provides that a property transfer is incident to the divorce if it occurs within one year of the divorce, or if it is related to the cessation of the marriage.
If the transaction qualifies as a Section 1041 transfer, it is not subject to taxation and the basis of the asset carries over to the receiving spouse.
Special Rules Relating to Timing of Transfer
There are special rules relating to the timing of the transfer. To achieve the most advantageous financial outcome for a divorcing client, family law attorneys should consider how these special rules apply to their clients.
The One-Year and Six-Year Tests
Let’s look at some key property transfer benchmarks on the divorce timeline:
Source: Thomson Reuters Checkpoint, 601 Applicability of IRC Sec. 1041
Transfers Taking Place Within One Year of the Divorce
No support or evidence is required when a transaction takes place within one year of the divorce. The presumption is that property transferred between former spouses is merely a shifting around of jointly owned assets and therefore, is not subject to taxation. This rule applies even if the transferred property was acquired after the divorce was final.
Consider this example:
John and Beth were divorced in July 2017. In January 2018, John purchased stock for $50,000. John then transferred the stock to Beth in June 2018, which increased in value to $60,000, to satisfy an obligation to her as part of the divorce settlement. No gain or loss would be recognized by John or Beth for this transaction.
Transfers Taking Place Between the One-Year and Six-Year Anniversary of the Divorce
A transfer of property that occurs between the one-year and six-year anniversary must be made pursuant to a divorce or separation instrument to be presumed related to the cessation of the marriage and qualify for Section 1041 treatment. A divorce or separation instrument includes a decree of divorce or separate maintenance, a written separation agreement, or other court decree.
It is also worth noting that a divorce instrument includes amendments or modifications to the instrument. A divorce instrument that does not provide for a transfer of property can be later modified to include one and will therefore ensure that no gain or loss will be recognized.
Private Letter Ruling 9306015 provides an example of a transfer of property found to be related to the cessation of the marriage:
Mr. and Ms. Young divorced in 1988. In 1989, they entered into a settlement agreement, which provided that Mr. Young deliver to Ms. Young a promissory note for $1.5 million, which was secured by 71 acres of land. In 1990, Mr. Young defaulted on this obligation and entered into a later settlement agreement to transfer 59 acres of land (42.3 acres of the original 71 acres and 16.7 acres of land adjoining that tract). In accordance with the later settlement agreement, Mr. Young retained an option to repurchase the land for $2.2 million on or before December 1992. Mr. Young assigned the option to a third party, who exercised the option and bought the land from Ms. Young for $2.2 million. No gain or loss was recognized on the transfer of the property from Mr. Young to his former spouse. Ms. Young took the marital basis of the land and recognized a gain on the subsequent sale to a third party.
Transfers Taking Place After the Six-Year Anniversary of the Divorce
In general, property transferred more than six years after the divorce is final does not qualify for Section 1041 treatment.
Any transfer that is not pursuant to a divorce or separation instrument and occurs more than six years after the divorce becomes final is presumed to be unrelated to the cessation of the marriage. While the IRS guidance is unclear, there are special circumstances in which property transfers after the six-year mark would qualify as a tax-free transfer.
The presumption that a transfer was not related to the cessation of the marriage “may be rebutted only by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage. For example, the presumption may be rebutted by showing that (a) the transfer was not made within the one- and six-year periods described above because of factors which hampered an earlier transfer of the property, such as legal or business impediments to transfer or disputes concerning the value of the property owned at the time of the cessation of the marriage, and (b) the transfer is effected promptly after the impediment to transfer is removed.” (Source: Section 1.1041-1T(b), Q&A-7 of the Temporary Income Tax Regulations)
There is a documented case where the presumption that the transfer was not related to the cessation of the marriage was clearly rebutted.
In Private Letter Ruling 9235026 (May 29, 1992), the IRS ruled that the transfer of the wife’s interest in business property to her ex-husband was incident to the divorce even though the transfer occurred more than six years after the divorce. It was determined that the transfer was delayed because of a dispute over the purchase price and payments terms. After the disputed factors were resolved, the transfer was promptly completed. Temp. Treas. Reg. §1.1041-1T, A-7 specifically provides that the presumption may be rebutted only by showing that the transfer was made to effect the division of property owned by the former spouses at the time of the cessation of the marriage, and there were factors that hampered an earlier transfer of property.
To qualify for Section 1041 treatment, a transfer of property should take place before the six-year anniversary of a divorce and be supported by a divorce or separation agreement after the one-year anniversary of the divorce. In circumstances where the property transfer cannot be completed within a six-year time frame, the best support is a written divorce or separation agreement documenting the contemplated transfer, and support for why the transfer could not be completed during the six-year time frame. There are documented exceptions to the six-year rule, but the guidance is not clear and would surely be evaluated by the IRS based on the specific facts and circumstances surrounding the property transfer.
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Published on February 13, 2019
A-1: Generally, no gain or loss is recognized on a transfer of property from an individual to (or in trust for the benefit of) a spouse or, if the transfer is incident to a divorce, a former spouse.
At the time of the triggering event, the entire amount of the deferred tax liability will be due unless (1) in the case of a stock transfer described in Sec. 965 (i) (2) (A) (iii), a transfer agreement is entered into by an eligible transferor and an eligible transferee for stock transfers (Sec. 965 (i) (2) (C)); or (2) the S corporation shareho...
Corporations file this form for each transfer of the legal title of a share of stock acquired by the employee pursuant to the employee's exercise of an option granted under an employee stock purchase plan and described in section 423(c) (where the exercise price is less than 100% of the value of the stock on the date of grant, or is not fixed or determinable on the date of grant).
RSAs are shares of company stock that employers transfer to employees, usually at no cost, subject to a vesting schedule. When the stock vests, the fair market value (FMV) of the shares on that date is deductible by the employer and constitutes taxable W - 2 wages to the employee. Typically, employers withhold applicable federal, state, and ...
If a DB plan's cessation or reduction of future benefit accruals creates or increases a potential for reversion, the plan is deemed to have a partial termination. ... stock bonus or, effective for years after December 31, 1985, money purchase plans, can't revert back to the plan sponsor. ... The option to transfer benefits under the above ...
2. As an early step toward passing down wealth. If you're thinking about your legacy, gifting stocks can be a valuable tool, as opposed to liquidating and paying capital gains taxes. As of 2022 ...
(1) occurs within 1 year after the date on which the marriage ceases, or (2) is related to the cessation of the marriage. (d) Special rule where spouse is nonresident alien Subsection (a) shall not apply if the spouse (or former spouse) of the individual making the transfer is a nonresident alien.
Where stock from a discontinued trade is transferred to another trader who will deduct the cost of that stock in computing their trading profits, there are specific rules determining the value...
Spouses. Your spouse can use these benefits right away whether you're on active duty or have separated from service. If you separated from active duty before January 1, 2013, your spouse can use these benefits for up to 15 years after your separation from active duty.; If you separated from active duty on or after January 1, 2013, your spouse can use these benefits at any time.
The main benefit to these types of accounts is that assets can be transferred relatively quickly to a beneficiary, and the costly and timely process of probating the assets is avoided.
In the first type of case outlined, the extension of the transfer pricing rules to such situations and the disapplication of the valuation rules by CTA09/S162 (2) would, absent any other...
01. General Rule Internal Revenue Code section 1041 provides that a transfer between spouses, or former spouses, "incident to divorce" is not taxable in most circumstances. The transfer is treated like a gift. The transferee takes the transferor's tax basis in the property.
A transfer of employee stock options out of the employee's estate (i.e., to a family member or to a family trust) offers two main estate planning benefits: first, the employee is able to remove a potentially high growth asset from his or her estate; second, a lifetime transfer may also save estate taxes by removing from the employee's taxable ...
It provides that a property transfer is incident to the divorce if it occurs within one year of the divorce, or if it is related to the cessation of the marriage. If the transaction qualifies as a Section 1041 transfer, it is not subject to taxation and the basis of the asset carries over to the receiving spouse.
Prior to having a security made eligible for DTC services, an issuer must appoint a transfer / paying agent that will submit and adhere to an Operational Arrangements Agent Letter filed with DTC. The issuer's designated agent (s) will work with DTC on an ongoing basis on activities related to the servicing of its security.
more than one year after the cessation of the marriage.) Q-7: When is a transfer of property related to the cessation of the marriage? A-7: A transfer of property is treated as related to the cessation of the mar-riage if the transfer is pursuant to a di-vorce or separation instrument, as de-fined in section 71(b)(2), and the trans-
The AI boom is here, and Nvidia is reaping all the benefits. Shares of Nvidia exploded 28% higher Thursday after reporting earnings and sales that surged well above Wall Street's already lofty ...