When considering whether to transition your company to an Employee Stock Ownership Plan, one critical decision is whether the selling shareholder(s) should elect to defer (or avoid) capital gains taxes under IRC Section §1042. In our previous article, we outlined the importance of feasibility studies, which provide a roadmap and analysis of possible outcomes of an ESOP sale. Within that feasibility study, modeling scenarios in which the seller shareholder does or does not elect IRC §1042 is an essential step.
What Is IRC §1042?
IRC §1042 is a tax provision that enable sellers of closely held C corporations to defer or potentially eliminate the tax on capital gains when selling to an ESOP.
How Does it Work?
- The selling shareholder(s) sell company stock to an ESOP.
- To take advantage of IRC §1042, the selling shareholder must reinvest the sale proceeds into Qualified Replacement Property (“QRP”). QRP includes common stock, preferred stock, corporate fixed or floating rate bonds, or convertible bonds issued by operating companies incorporated in the U.S.
- Capital gains tax on the sale will not be owed until the QRP is sold, redeemed, or matures, at which point the taxpayer will recognize a capital gain on the difference between the amount received and the taxpayer’s basis in the original shares sold to the ESOP. If the QRP is still held at the time of the original owner’s death, however, the QRP is transferred to the beneficiary who receives a step-up in basis, thus eliminating all capital gains on the ESOP sale.
Why This Matters
Tax Efficiency – By deferring or potentially eliminating capital gains taxes, shareholders keep more of the proceeds from the sale working for them.
Wealth Transfer – If QRP is still held when the seller passes away, the step-up in basis can significantly reduce estate taxes and preserve more wealth for heirs and beneficiaries.
What About Liquidity?
A common concern for selling shareholders is liquidity – the ability to have funds readily available for personal use, reinvestment, or philanthropy. While §1042 can be advantageous from a tax perspective, reinvesting the majority of the sale proceeds into QRP could mean those funds are not immediately accessible. However, a monetization strategy can help address this.
This typically begins with the seller taking a portion of the sale proceeds (often around 10%) as cash. For the remaining amount, the seller can enter into a monetization loan. Essentially, this means the seller borrows money against the QRP. The proceeds of the monetization loan are then used to purchase floating rate notes, a qualifying QRP. Any remaining proceeds (outside of the 10% margin requirement ) can be generally be invested in assets that may or may not qualify as QRP, without triggering capital gains from the sale. However, most providers of monetization loans will require that some amount of additional collateral be maintained at their firm, or otherwise accessible (up to an additional 10.0% depending on the type of assets. This strategy allows the seller to take advantage of §1042 while still having the liquidity needed for other investments, estate planning, or philanthropic goals.
How do I Elect §1042?
The seller must reinvest the proceeds from the sale into QRP within a 15-month period, beginning 3 months before the sale date and ending 12 months after the sale date. Additional requirements include:
- The selling shareholder must have held the stock for at least three years before the sale date;
- The company must be a domestic C corporation at the time of the sale;
- At least 30.0% of the company’s stock must be held by the ESOP following the transaction; and
- A statement of consent, statement of election, and statement of purchase must be filed with the IRS.
Deciding Between Electing 1042 or Not
When deciding whether to elect §1042, it’s important for the seller to consider their liquid net worth, estate and philanthropic goals, and succession plan. Questions one should ask include the following:
Liquid Net Worth – Do you need immediate access to the sale proceeds for other investments or personal obligations? Does tying up capital in QRP affect your financial security or lifestyle?
Estate and Philanthropic Goals – Are you looking to pass wealth onto heirs in a tax-efficient way? Would you like to donate some of your proceeds to charitable causes?
Succession Plan – How does selling to an ESOP fit into your broader retirement strategy? Do you want to remain involved in the company, and if so, for how long?
Conclusion
Electing §1042 can offer significant tax benefits by deferring, and potentially eliminating, capital gains for business owners transitioning their companies to an ESOP. However, other factors including immediate liquidity needs, estate planning goals, and the seller’s broader retirement plan, play a vital role. A thorough feasibility study evaluates these dimensions, modeling the quantitative outcomes (i.e., how much you might save in taxes) that you can weight against qualitative considerations.
Acuity Advisors can help you map out a plan that optimizes your personal and business goals, whether or not you ultimately choose to elect §1042.