Owners of closely held C corporations who wish to diversify their holdings may find the right opportunity in a Section 1042 exchange when selling business shares to an employee stock ownership plan (ESOP).
Internal Revenue Code Section 1042 allows qualifying individuals, partnerships, estates, and trusts that sell equity in a C corporation to an ESOP to elect not to recognize long-term capital gains from the sale with regard to federal income taxes.
There are, however, several specific criteria that must be met in order for the selling shareholder to qualify for this significant tax deferral benefit. And it’s important to understand that a 1042 transaction can be complex. Selling shareholders who fail to comply with requirements can find themselves owing significant capital gains tax bills if they don’t proceed with an abundance of care.
The benefits of a Section 1042 election probably aren’t a primary motivation to sell a business in the first place, but the advantage is significant and could tip the scales toward an ESOP sale over a third-party sale to a strategic buyer.
How does a 1042 exchange work, and what are the mistakes and pitfalls a selling shareholder needs to avoid? Let’s take a look.
What is a Section 1042 Rollover?
As stated above, IRC Section 1042 allows the selling owner of a closely held C corporation to an ESOP to indefinitely defer capital gains tax on that stock sale—provided certain requirements are met.
Business owners who have invested their resources, time, and labor over decades to build a valuable business may find, when divesting to retire or diversify their investments, that it’s an attractive option to be able to defer long-term capital gains tax on this sale.
Who’s Likely to Want to Elect a Section 1042 Exchange?
For sellers who can invest the sale proceeds in a qualifying replacement property without creating personal liquidity, a Section 1042 exchange may make sense. Some sellers choose to use the sale proceeds as collateral on a margin loan, in order to meet the qualified replacement property (QRP) requirement while still creating a liquidity event for their use. It’s advised to work closely with a qualified tax professional before proceeding with borrowing tactics to accomplish the tax deferral.
After electing the 1042 exchange and investing in the QRP, the seller can choose the year in which to sell the QRP, exerting some control over the timing of capital gains taxes. A partial 1042 election is an option for sellers who want to defer capital gains on only part of the sale proceeds.
The tax deferral continues until the taxpayer has a disposition (sale) of the QRP. What events are not disposition events?
If the seller elects a 1042 exchange and does not sell the QRP before their death, the step-up in basis eliminates capital gains taxes on the ESOP sale proceeds. So, transfer upon death, transfer in connection with a divorce, and gifts of QRP are not considered dispositions.
Who Is Eligible for a Section 1042 Election?
The basic requirements for electing a Section 1042 exchange are several:
- The company sold must be a domestic C corporation.
- At least 30% of the company’s equity must be sold to the ESOP.
- Stock sold to the ESOP has to be common stock (or equivalent).
- The seller has to have held the stock for at least three years before selling to the ESOP.*
- Within a 15-month period that starts three months before closing on the sale and ends 12 months after closing, the seller must purchase qualified replacement property. (The funds invested in the QRP therefore aren’t required to be actual proceeds of the sale, but the amount for which the seller wants to defer federal capital gains taxation.)
- If the seller chooses to elect Section 1042 and continue working for the ESOP company, they and certain members of their families are prohibited from receiving share allocations of the shares they sold, or any shares that were subject to a 1042 election when contributed to the ESOP.
- Owners of more than 25% of an ESOP sponsor company who are employed by the company, and certain members of their families, are also prohibited from receiving allocations from shares that were subject to 1042 election.
*Note: The IRS has issued a private letter ruling that allowed shareholders of a C corp to include the period they owned a predecessor LLC that was merged into a newly created C corporation in the required three-year holding period described here. In that case, the tax basis of the shareholders’ stock was the same as their basis in their LLC membership prior to the business reorganization.
What Does and Does Not Qualify as a 1042 QRP?
Qualified replacement properties must be securities issued by U.S. operating corporations. Examples of qualified replacement property include common stock, preferred stock, convertible bonds, and corporate fixed rate notes, and corporate floating rate notes.
If a U.S. corporation uses 50% or more of its assets in an active trade or business and doesn’t receive greater than 25% of its gross receipts from passive income, the securities can be used as qualifying replacement property.
Investments that are not qualified replacement properties include bank CDs, mutual funds, foreign securities, municipal bonds, real estate investment trusts, exchange traded funds, master limited partnerships, and U.S. government bonds.
What is a Floating Rate Note?
Also called an ESOP bond, an FRN is a corporate debt instrument with an interest rate that in most cases resets every 90 days. FRNs often have a put feature that allows the holder to force the issuer to repurchase the note at a specified percentage of the purchase price, mitigating risk. Maturity often ranges from 40–50 years.
How Does a Seller Elect a Section 1042 Exchange?
Along with meeting the basic requirements listed above and investing in eligible QRP, three statements must be filed with the IRS to successfully communicate intent to elect Section 1042:
- Statement of consent — The ESOP company is required to provide written consent to the seller to defer taxes, and to consent to the application of certain IRS penalties if shares purchased by the ESOP are sold within three years or are allocated to the selling shareholder(s) and/or their families.
- Statement of election — The seller must provide express written intent to elect not to recognize capital gains with respect to the sale of C corp stock under IRC Section 1042.
- Statement of purchase — The seller must provide a signed and notarized statement that they have completed the sale of stock to the ESOP and declared the purchase of specific QRP securities with respect to the ESOP sale.
Without communicating intent to choose a Section 1042 election, the seller hasn’t fully complied with tax requirements — so it’s critical to complete these communication steps.
Are There Disadvantages to a 1042 Election?
The first thing to keep in mind is that Section 1042 election is available only for sellers of C corporations. If the business is an S corp, that could require conversion, and given the recognition period requirements for conversions, this may complicate a company’s tax situation.
It’s also important to note that, in order to qualify for 1042 election, sale proceeds must be available within 12 months of closing the deal— rather than the seller taking a personal note.
And certainly not least of all, many selling business owners prefer to remain with the company as an employee after the ESOP sale. Those who choose an ESOP 1042 election (and their family members) can’t participate in ESOP allocation of the shares they sold.
Selling your closely held business to an ESOP can offer significant benefits not only to you, but also to your employees, the successful company you’ve established, and the community where you do business. Learn more about how an ESOP transaction works and all the parties involved when you download our infographic, The Mechanics of an ESOP Transaction. Just click below to get yours.