PLR 200827018 is a private letter (PLR) ruling that allowed two selling shareholders of a C Corporation to include the time period that they owned a predecessor LLC that was merged into a newly created C Corporation in the 3-year holding period defined in IRC Section 1042(b)(4) - Sales of stock to employee stock ownership plans or certain cooperatives – Requirements to qualify for nonrecognition – 3-year holding period.
The PLR notes that the merger was part of a IRC Section 368(a)(1)(F) - Definitions relating to corporate reorganizations - Reorganization - In general reorganization ("a mere change in identity, form, or place of organization of one corporation, however effected").
- Precedential status - IRC Section 6110(k)(3) - Precedential status provides that a private letter ruling cannot be "used or cited as precedent."
- Nonrecognition of gain – The shareholders requested a ruling so they can elect to sell their stock to an ESOP under IRC Section 1042(a) - Sales of stock to employee stock ownership plans or certain cooperatives – Nonrecognition of gain and defer long-term capital gains taxation on the sale.
(a) Nonrecognition of gain
(1) the taxpayer or executor elects in such form as the Secretary may prescribe the application of this section with respect to any sale of qualified securities,
(2) the taxpayer purchases qualified replacement property within the replacement period, and
(3) the requirements of subsection (b) are met with respect to such sale, then the gain (if any) on such sale which would be recognized as long-term capital gain shall be recognized only to the extent that the amount realized on such sale exceeds the cost to the taxpayer of such qualified replacement property.
IRC Section 1042 Requirements - IRC Section 1042(b) - Sales of stock to employee stock ownership plans or certain cooperative – Requirements to qualify for nonrecognition defines four requirements to qualify for Section 1042 deferred tax treatment:
(b) Requirements to qualify for nonrecognition
A sale of qualified securities meets the requirements of this subsection if—
(1) Sale to employee organizations
The qualified securities are sold to—
(A) an employee stock ownership plan (as defined in section 4975 (e)(7)), or
(B) an eligible worker-owned cooperative.
(2) Plan must hold 30 percent of stock after sale
The plan or cooperative referred to in paragraph (1) owns (after application of section 318 (a)(4)), immediately after the sale, at least 30 percent of—
(A) each class of outstanding stock of the corporation (other than stock described in section 1504 (a)(4)) which issued the qualified securities, or
(B) the total value of all outstanding stock of the corporation (other than stock described in section 1504 (a)(4)).
(3) Written statement required
(A) In general
The taxpayer files with the Secretary the written statement described in subparagraph (B).
A statement is described in this subparagraph if it is a verified written statement of—
(i) the employer whose employees are covered by the plan described in paragraph (1), or
(ii) any authorized officer of the cooperative described in paragraph (l), consenting to the application of sections 4978 and 4979A with respect to such employer or cooperative.
(4) 3-year holding period
The taxpayer's holding period with respect to the qualified securities is at least 3 years (determined as of the time of the sale).
- Employer securities – IRC Section 409(l) - Qualifications for tax credit employee stock ownership plans - Employer securities defined provides a definition of employer securities:
(l) Employer securities defined
For purposes of this section—
(1) In general
The term "employer securities" means common stock issued by the employer (or by a corporation which is a member of the same controlled group) which is readily tradable on an established securities market.
(2) Special rule where there is no readily tradable common stock
If there is no common stock which meets the requirements of paragraph (1), the term "employer securities" means common stock issued by the employer (or by a corporation which is a member of the same controlled group) having a combination of voting power and dividend rights equal to or in excess of—
(A) that class of common stock of the employer (or of any other such corporation) having the greatest voting power, and
(B) that class of common stock of the employer (or of any other such corporation) having the greatest dividend rights.
(3) Preferred stock may be issued in certain cases
Noncallable preferred stock shall be treated as employer securities if such stock is convertible at any time into stock which meets the requirements of paragraph (1) or (2) (whichever is applicable) and if such conversion is at a conversion price which (as of the date of the acquisition by the tax credit employee stock ownership plan) is reasonable. For purposes of the preceding sentence, under regulations prescribed by the Secretary, preferred stock shall be treated as noncallable if after the call there will be a reasonable opportunity for a conversion which meets the requirements of the preceding sentence.
(4) Application to controlled group of corporations (see Code)
(5) Nonvoting common stock may be acquired in certain cases (see Code)
- Qualified securities – IRC Section 1042(c)(1) - Sales of stock to employee stock ownership plans or certain cooperative – Definitions; special rules – Qualified securities defines qualified securities as employer securities that are held by a closely held C corporation company that has not received its stock through certain stock arrangements:
(1) Qualified securities
The term "qualified securities" means employer securities (as defined in section 409(l)) which—
(A) are issued by a domestic C corporation that has no stock outstanding that is readily tradable on an established securities market, and
(B) were not received by the taxpayer in—
(i) a distribution from a plan described in section 401 (a), or
(ii) a transfer pursuant to an option or other right to acquire stock to which section 83, 422, or 423 applied (or to which section 422 or 424 (as in effect on the day before the date of the enactment of the Revenue Reconciliation Act of 1990) applied).
- Other provisions – IRC Section 1042 - Sales of stock to employee stock ownership plans or certain cooperatives contains additional requirements, including the IRC Section 1042(a)(2) requirement to purchase qualified replacement property (generally stocks or bonds of domestic companies) within the replacement period (three months before to twelve months after the sale):
(c) Definitions; special rules
(1) Qualified securities
(2) Eligible worker-owned cooperative
(3) Replacement period
(4) Qualified replacement property
(A) In general
(B) Operating corporation
(C) Controlling and controlled corporations treated as 1 corporation
(D) Security defined
(5) Securities sold by underwriter
(6) Time for filing election
(7) Section not to apply to gain of C corporation
(d) Basis of qualified replacement property
(e) Recapture of gain on disposition of qualified replacement property
(1) In general
(2) Special rule for corporations controlled by the taxpayer
(3) Recapture not to apply in certain cases
(f) Statute of limitations
(g) Application of section to sales of stock in agricultural refiners and processors to eligible farm cooperatives
(1) In general
(2) Qualified refiner or processor
(3) Eligible farmers' cooperative
(4) Special rules
- Treasury Regulation - Sec. 1.1042-1T Questions and answers relating to the sales of stock to employee stock ownership plans or certain cooperatives (temporary) answers the following questions in a Q&A format:
1. What does section 1042 provide?
2. What is a sale of qualified securities for purposes of section 1042(b)?
3. What is the time and manner for making the election under section 1042(a)?
4. What is the basis of qualified replacement property?
5. What is the statute of limitations for the assessment of a deficiency relating to the gain on the sale of qualified securities?
6. When does section 1042 become effective?
Other Section 1042 Transaction Thoughts
- The sellers can avoid taxation upon the death of the seller, as the heirs will receive the property with a stepped-up basis.
- Two or more shareholders may combine their sales to meet the 30% requirement.
- Certain allocation restrictions apply to the selling shareholder(s) and certain relatives. In most cases, they will be unable to share in the allocation of the ESOP shares, even if they remain employees of the company.
- Using ESOP Planning to React to Changing Times notes how an increase in capital gains rates, which could happen in the near future, could create an increase in Section 1042 transactions.
- Analysis of IRC Section 401(a)(35) Proposed Regulations – Definition of Publicly Traded and the Impact on Other ESOP Provisions discusses how IRC Section 401(a)(35) Regulations - REG–136701–07 - Diversification Requirements for Certain Defined Contribution Plans could impact thinly traded companies, including the impact on Section 1042.
- REITs as Section 1042 Qualified Replacement Property discusses how an argument has been made that certain real estate investment trusts (REITs) may be eligible as qualified replacement property.
- ESOPs and Charitable Contributions discusses how an IRC Section 1042 sale can be combined with charitable giving to achieve the seller's estate planning objectives.