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IRC Section 1042 Tax Deferral: Part Two

November 8, 2016

This is the second article in a five part series that reviews the Section 1042 Capital Gains Tax Deferral alternative with respect to ESOP structures.

Part one of this series discussed the potential tax benefit available to owners who sell their business to to an Employee Stock Ownership Plan (“ESOP”) when electing the Section 1042 Capital Gains Tax deferral.  In this article, we will further define Section 1042 of the IRS Code.

Basic Requirements for Section 1042 Eligibility
The Section 1042 election is a “like-kind” exchange in that the seller can defer all or a portion of proceeds from the sale of stock by reinvesting the proceeds in similar assets. These assets are referred to as Qualified Replacement Property (QRP). By investing sale proceeds in QRP, the sale is completed on a tax-deferred basis.  Even more significant, if the QRP is appropriately selected, capital gains taxes may be avoided completely for the seller and his or her estate, likely resulting in a step-up in basis for the decedent’s heirs. The provision is intended to incentivize business owners to sell the business to an ESOP in order to foster wealth creation and job preservation by providing employees a stake in the company going forward.

The basic requirements for Section 1042 eligibility are as follows:
Section 1042 Basic Requirements
* This is an aggregate value. Multiple shareholders may sell shares in order to meet the 30% threshold.

** QRP is defined as debt or equity instruments of domestic operating businesses, publicly or privately held. It does not include mutual funds, government debt, real estate or municipal securities.
*** It can be any dollar amount equal to the amount of the proceeds on which the seller desires to defer capital gains taxes.
**** Additionally, the seller cannot have received the stock through the exercise of stock options or certain other employee stock arrangements.

There are other provisions that govern the use of Section 1042 of which sellers should be aware.  If selling shareholders take advantage of the Section 1042 tax deferral, none of the shares in the ESOP may be allocated to ESOP accounts of the seller(s), relatives of the seller(s), non-selling shareholders of more than 25% of the company’s stock or family members of more than 25% shareholders, if they own the stock by what is referred to as attribution (i.e. they are a spouse of a 25% shareholder).  There is one exception to this regulation.  Lineal descendants of the selling shareholder(s) may be allocated a total of 5% of the stock as long as they are not treated as more than 25% shareholders by attribution.

There are many technical factors that need to be addressed by business owners and their advisors when implementing an ESOP and 1042 election.  Owners interested in pursuing a sale to an ESOP need advisors with deep experience in structuring these transactions, making sure the guidelines and regulations are met and that the business owner receives maximum value when selling all or part of their business.

In the next article in this series we will illustrate an example of implementing an ESOP with a Section 1042 Capital Gains Tax deferral strategy.

 

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