Tax treatment of ESOPs: Your guide to Internal Revenue Code Section 1042
By Dan Markowitz, CPA
May 19, 2022
Shareholders and owners of closely held businesses who are looking for the right exit strategy to diversify their portfolio and plan for the next phase of life have numerous alternatives to consider. Among these, perhaps the most tax-favorable option is selling their shares to an Employee Stock Ownership Plan (ESOP).
An exit strategy should not be selected based solely on tax consequences, but if the decision is made to sell the business to an ESOP, the transaction can be structured strategically to bring significant tax benefits to selling shareholders. For shareholders who meet certain conditions and requirements,
Section 1042 of the Internal Revenue Code provides an opportunity to defer capital gains taxes on the sale.
This tax-free rollover, also known as the 1042 transaction, is one of the most effective tax provisions passed to encourage the growth of ESOPs. Read on to learn more about Section 1042 and understand whether it’s right for you.
Requirements of Section 1042
Not every sale of stock to an ESOP is eligible for a 1042 rollover. To qualify, certain requirements must be met by both the company and selling shareholder(s).
First, the 1042 rollover is only available to C Corporations. If an S Corporation wants to utilize the 1042 rollover, the company may choose to convert to a C Corporation prior to the sale to the ESOP. There is no required length of time a company must have C status before electing Section 1042, so the company can receive the deferred tax benefits immediately after changing status. However, by converting, the company will no longer benefit from the significant federal tax advantages offered to an S Corporation ESOP. The company must consider whether a change in status is the best option, or if the S Corporation tax advantages outweigh the benefits gained from the 1042 rollover. The company may, however, convert back to an S Corporation five years after the conversion to a C Corporation.
Meanwhile, the selling shareholder is required to have held the stock for a minimum of three years prior to the sale to the ESOP. The stock sold to the ESOP must be common stock with the greatest voting power and dividend rights. Following the transaction, the shareholder is required to reinvest the proceeds into Qualified Replacement Property (QRP). This must be done within a 15-month period, starting three months before the ESOP transaction, and ending 12 months after.
Immediately following the ESOP transaction, the ESOP must own at least 30% of the company’s total equity value. If a single selling shareholder does not have enough stock to meet the 30% threshold, two or more shareholders may combine their sales to meet or exceed 30%, as long as the sales are part of a single transaction.
If both the selling shareholder(s) and company meet the requirements of the 1042 transaction, the seller(s) can elect Section 1042 when filing their taxes. The election can be done on a shareholder-by-shareholder basis. To successfully elect Section 1042, three primary documents need to be properly completed and submitted on time:
- The Statement of Consent, signed by an officer of the sponsor company, gives consent to the selling shareholder’s election to defer taxes. By signing, the company is also accepting certain penalties that would occur if 1042 regulations are broken. For example, if shares purchased by the ESOP are sold within the required three-year holding period or are allocated to the selling shareholder(s) or their families.
- The Statement of Election is completed by the selling shareholder(s) to confirm their intention to elect nonrecognition treatment with respect to the stock sale under Section 1042. This statement is then attached to the seller’s tax return for the filing year in which the transaction takes place.
- The Statement of Purchase is signed by the selling shareholder(s) and acknowledged by a public notary. This describes the QRP, date of purchase and cost, and declares that specific securities represent QRP with respect to the stock sold to the ESOP.
Qualified replacement property
The Section 1042 rollover is considered a “like-kind” exchange. The selling shareholder currently owns shares of a U.S. operating entity (their business), and under 1042, the proceeds from the sale to the ESOP must be reinvested in similar assets (stocks and bonds of another U.S. operating company).
Thus, securities that qualify as QRP are equity and/or debt of domestic (U.S.) corporations. In addition, specific security issuances are issued for the purpose of 1042 reinvestment. To be considered a domestic operating company, the corporation must pass the asset and income tests:
- Asset test: The corporation must use more than 50% of its assets in the active conduct of a trade or business.
- Income test: The corporation may not have passive income exceeding 25% of its gross receipts in the year preceding the purchase.
Securities which are eligible QRP include:
- Common stock.
- Preferred stock.
- Convertible bonds.
- Corporate fixed-rate notes.
- Corporate floating rate notes.
- Securities of other privately held corporations (given other requirements are met).
Other types of securities do not qualify as QRP under Section 1042, such as federal government bonds, municipal bonds, bank CDs, exchange traded funds, mutual funds, real estate investment trusts and foreign securities.
Benefits of Section 1042 election
Under the 1042 rollover, capital gains are not recognized until the QRP is liquidated (at a future date, after a required minimum holding period). Herein lies the key benefit — the ability for the selling shareholder(s) to defer capital gains taxes on the sale of shares to the ESOP. Deferral gives the shareholder(s) more control over the timing of their taxes, allowing them to postpone gain recognition until a time that is more beneficial (i.e., a time with lower tax rates). It also allows the shareholder(s) to invest and earn with money that would have been taxed away. Additionally, if the QRP has not been liquidated at the time of the selling shareholder’s death and becomes part of the estate, the QRP receives a stepped-up basis, and capital gains will be eliminated.
Is a Section 1042 election right for me?
Section 1042 is best for a selling shareholder who can immediately invest the sale proceeds into QRP, without the need to create personal liquidity. If the selling shareholder doesn’t need the full liquidity, they can borrow funds against their seller note to get the full proceeds invested within the required timeframe. However, Section 1042 is not all or nothing — shareholders may use a partial 1042 election if they wish to defer capital gains taxes on only part of the sale proceeds. With a partial election, sellers have more flexibility in how the proceeds not invested in QRP can be used, though it is important to note that this portion of proceeds will be taxable.
The decision of whether or not to elect Section 1042 depends largely on the selling shareholder’s specific objectives and circumstances. Sellers should determine whether the 1042 requirements can be met without extensive effort and expense. They should consider their liquidity needs, as well as the potential downsides of Section 1042 election, including:
- The sale proceeds must be available within 12 months of the transaction to be reinvested into QRP. Thus, to qualify for 1042, the seller must take a lump sum instead of a personal note over several years, or borrow against the transaction to have the full funds available.
- Capital gains rates could experience unforeseen increases in the future, making deferring capital gains riskier.
- Investment options for the ESOP sale proceeds are limited, as only U.S. domestic company stocks and bonds qualify as QRP.
- A selling shareholder who plans to be an employee of the company after the 1042 transaction cannot participate in the ESOP allocation of the shares they sold to the ESOP.
- Family members of the selling shareholder are also excluded from participating in those shares of the ESOP.
Section 1042 is complicated and may require additional time and costs to implement successfully. To ensure the 1042 transaction is structured to maximize the value of the sale and avoid potential tax complications down the line, consult with an experienced and trusted ESOP adviser.
Dan Markowitz (dmarkowitz@boulaygroup.com), CPA is a partner at Boulay. Boulay knows why ESOP strategies and motivations differ greatly from those of a typical tax-driven entity. With more than 115 ESOP clients, they provide solutions at all stages of the ESOP from structuring and sustainability to plan design review as well as third-party administration, assurance and tax services. This concentration creates a team well-versed in the regulatory requirements of both young and established ESOPs.
The Minnesota Center for Employee Ownership serves as a free unbiased source for education and resources around all forms of employee ownership. With 52,000 business owners over the age of 55 in Minnesota exiting their business in the next 3–5 years, there is a crisis looming. What will happen to their legacy, employees, community? Business owners will look to their advisers on how best to exit. Contact us for more information on how we can be a resource for you at www.mnceo.org or Sue Crockett, executive director at scrockett@mnceo.org.
