A Little Known Gem in the Tax Code: Section 1042

Filed under: Business Law

For business owners evaluating wealth diversification and business succession alternatives can be a daunting and time consuming task. It is no secret that today’s business owners live in a complex and ever changing tax environment. However, to most business owners Employee Stock Ownership Plans (ESOP) and the rules and regulations governing them are little known and often misunderstood alternative in wealth diversification and business succession planning. However, few alternatives offer greater after tax proceeds than a little known tax planning gem often referred to as a “1042 Exchange.” A properly executed Internal Revenue Code Section 1042 tax-deferred sale to an ESOP for full fair market value can provide significant tax benefits.

WHAT IS INTERNAL REVENUE CODE SECTION 1042?

Internal Revenue Code Section 1042 provides for an election that allows individuals, partnerships, trusts, and estates that sell shares of stock of a C corporation to an ESOP to not recognize the long-term capital gain realized in connection with the sale for federal income tax purposes. Much like an Internal Revenue Code Section 1031 exchange in the real estate context, the recognition of the capital gain is deferred until a future point in time, or even eliminated. Section 1042 treatment must be properly elected by the taxpayer within the time frame for filing the tax return for the year of the sale to the ESOP.

HOW DOES A 1042 EXCHANGE WORK?

The basic requirements for making the 1042 Election include the following:

  • The company sponsoring the ESOP must be a C corporation. (In some cases it is actually worth converting from an S corporation to a C corporation, even though you cannot convert back for five years.)
  • Immediately following the sale to the ESOP, the plan (ESOP) must own at least 30% of the company’s stock.
  • The seller must, within 12 months, invest the proceeds of the sale in “Qualifying Replacement Property” (“QRP”) — U.S. domestic stocks and bonds. (Mutual funds, real estate, and certain other investments are not allowed.)
  • The seller must have held stock in the corporation for at least three years prior to the sale.

If all the requirements are met, the 1042 Election can have significant tax advantages for the seller. First, the capital gains tax that would be paid due to the sale of the company stock can be deferred. The basis in that stock becomes the basis in the QRP. The capital gains tax is not paid until those securities are sold. Second, for any replacement property still owned by the seller at his or her death, there is a step-up in basis to the market value at that time, thus eliminating the capital gains tax entirely.

EXAMPLE

  • Assume an owner’s basis in his company is $1,000,000. The market value of the company is $4,000,000 when he sells 100% of the company to an ESOP.
  • Unrealized appreciation at time of sale to the ESOP is $3,000,000.
  • Assuming a combined (federal and state) 30% capital gains tax rate, the tax would be $900,000 if there were no 1042 election.
  • Assume the seller makes a 1042 election (which must be filed with his personal tax returns) and all proceeds are invested into QRP.
  • The basis of the new securities is deemed to be $1,000,000.
  • Twenty years down the road, assume the QRP have grown to $11,000,000. (That’s appreciation of a little over 5% per year.) The unrealized appreciation would be $10,000,000. If the securities were sold at that time, the 30% capital gains tax would be $3,000,000.
  • Assume the individual dies 20 years from now, still holding the QRP. Then the basis is stepped-up to the $11,000,000 fair market value at death. Consequently, the $3,000,000 capital gains tax disappears completely.

ADVANTAGES OF A 1042 ELECTION

A seller can postpone capital gains. If the QRP has not been sold by the time the seller dies, there is a step-up in basis, thus eliminating capital gains altogether. Even if not deferring capital gains until death, the seller gets to choose the year in which he sells the QRP, thus having some control over the timing of the taxes. A partial 1042 election is also permitted if the seller wishes to defer capital gains on only part of the proceeds of the sale.

Some brokerage firms and financial institutions are willing to lend around 70% on a portfolio including equities. Therefore, theoretically a person could put the sale proceeds into a QRP portfolio and then borrow up to 70% of that amount to generate a retirement income, paying only interest on the debt each year. At death, when the capital gains have been eliminated, the portfolio can be partially liquidated in order to pay off the entire debt.

DISADVANTAGES OF A 1042 ELECTION

If the corporation being sold is an S corporation, then it must first convert to a C corporation in order to use a 1042 election. The conversion to C corporation from S corporation can be made on or right before the stock sale transaction is closed.

In order to qualify, the proceeds from the sale must be available within 12 months of the sale to the ESOP. Therefore, to have all the proceeds qualify, the seller must get a lump sum, instead of taking a personal note over several years. This may require involving a lender.

If the intent is to only buyout one shareholder, who happens to own less than 30% of the company, then you can’t meet the requirement that the ESOP must own at least 30% of the company right after the sale. In order to qualify for the delayed capital gains, the sale must be directly to the ESOP, as opposed to retiring some shares and selling only part to an ESOP. There are times when a large sale to an ESOP creates problems with the debt service.

Deferring capital gains can be risky since capital gains rates could go up in the future. In order to purchase QRP, the seller must not buy mutual funds or foreign investments. The seller is limited to U.S. domestic stocks and bonds. If borrowing against a QRP portfolio in order to generate retirement income, then the seller needs to consider some worse case scenarios involving large drops in the stock or bond markets.

If the seller plans to be an employee after the sale, but makes a 1042 election, then he cannot participate in the ESOP allocation of the shares he is selling to the ESOP. (Family members would also be precluded from participating in those shares inside of the ESOP.)

CONCLUSION

When a business owner considers the income tax benefits possible with a sale to an ESOP, along with the likelihood that incentivized and rewarded employees will be more motivated and productive, he or she may conclude that a tax-deferred sale to an ESOP is the best wealth diversification or business succession alternative available.

Of course, every situation is different and there is no one size fit all solution for a business owner who is evaluating wealth diversification and business succession alternatives. Business owners should consider all of the available options and compare, the friction costs, investment restrictions, and the after-tax proceeds the business owner will receive under each alternative.

Our experienced business planning attorneys can help you with issues related to wealth diversification and business succession. Please call our office to schedule an appointment, and we will be happy to examine your situation and explain the options available to you.

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