ESOP Tax Advantages: The Magic of IRC Section 1042
Many business owners are looking for ways to sell their businesses. An ESOP combined with an election under Section 1042 of the Internal Revenue Code may provide the greatest post-tax return on the sale of the business. Section 1042 permits the deferral of the gain on the sale, perhaps permanently, if owners follow the requirements of the Code Section. The requirements generally are as follows:
1. The sale must be to an employee stock ownership plan or an eligible worker-owned cooperative.
2. The plan must hold 30% of the stock after the sale.
3. The business owner must meet certain filing requirements.
4. Stock sold to the plan must have been held for at least three years and it cannot have been received as compensation, under a stock option, or pursuant to an employee stock purchase plan.
5. The corporation must be a C corporation.
6. The proceeds of the sale must be invested in qualified replacement property (QRP) during the 15-month period starting three months prior to the sale and ending 12 months after the sale.
7. QRP means any type of security, including bonds, notes, debentures, stock, etc. issued by domestic operating corporation which had no more than 25% passive investment income. In addition, the corporation in which the proceeds are invested must be an operating corporation, meaning more than 50% of the assets are used in the active conduct of the trader business. Therefore, owners may not purchase mutual funds or government securities.
How does it play out post transaction?
Once a business owner acquires a QRP, they have no taxable gains unless and until the they sell the QRP. Many taxpayers plan on holding their QRP until death, at which point, under current law, the QRP will receive a step-up in basis. A step-up basis means they pay no income tax on the sale of the company.
The taxpayer may elect to sell some of the securities during his or her lifetime. Only that portion of the securities will be subject to tax, based on the basis of the original stock sold to the ESOP.
Choosing QRP that a taxpayer may want to hold until death can be tricky. Therefore, some taxpayers buy a very long-term note from a corporation; borrow against the note; and then buy stocks with the borrowed proceeds. Then, the taxpayer can trade during his lifetime. The only gain on those transactions is the gain from the point of acquisition of the securities bought with the borrowed proceeds—not the underlying gain from the original sale to the ESOP. The taxpayer can invest the QRP in a public company, a private company, or even a startup company.
Using Section 1042 can substantially enhance the assets available to a selling shareholder after retirement.
Mike Sanchez is a Member in Sherman & Howard who practices employee benefits, tax and healthcare law. He counsels his clients on planning and structuring employee benefits plans. Mike often serves a legal adviser to professional services entities and coordinates with other Sherman & Howard attorneys to address these clients’ diverse legal needs.