ESOP Tax-Deferred Rollover
February 27, 2012
In our next few blog posts, we’re going to explore the benefits of the ESOP as they relate specifically to selling shareholders, the company and employees. To start, we’re going to focus in on one of the key benefits of an ESOP transaction to selling shareholders.
So, why sell to an ESOP? You, as a business owner, have built a great business and have numerous options for your liquidity event. One factor that might affect your decision is the ability for you to defer capital gains on the sale.
We’re going to dive deeper into the benefits of an ESOP by investigating what it takes to qualify for one of the biggest tax advantages of the ESOP – the §1042 rollover. Shareholders who sell to an ESOP can defer capital gains taxes on proceeds resulting from the sale. That’s right, an ESOP provides a great way for owners to exit a business, with the proceeds from the sale potentially qualifying for a tax-deferred rollover under §1042 of the Internal Revenue Code.
The basic criteria for rolling over proceeds from a sale to an ESOP include the following:
- The company involved in the transaction is a domestic C corporation;
- 30% or more of the company’s equity value must be sold to the ESOP;
- The seller must have held the stock being sold for three or more years;
- The stock sold to the ESOP must be common stock or its equivalent, with the “greatest voting power and dividend rights”;
- The seller must “roll over” the sale proceeds into Qualified Replacement Property (“QRP”) during a specific 15-month period (three months before to twelve months after date of sale);
- QRP is defined as debt or equity securities of U.S. domestic operating companies that do not derive more than 50% of their income from passive means
So, here’s the basic transaction:
A business owner hires a great ESOP firm to help them structure the deal and raise the capital to fund it and then sells at least 30% of the business to the ESOP. The important point here is that the owner does not have to sell all of the business in one transaction (although such is often the case). If they choose, they can do a partial liquidity plan and maintain control. As long as the stock being sold qualifies and the seller purchases Qualified Replacement Property three months prior or within 12 months after the date of the sale (as we outlined above), the sale qualifies for capital gains tax deferral. As with anything involving the internal revenue code, the transaction must be carefully structured to make sure it qualifies, but in reality, this is the basic transaction.
As with any sales event of this magnitude, seeking advice from a seasoned professional is crucial. Whether it’s from us at Butcher Joseph Hayes or your own financial and business professional with comparable experience, we highly recommend engaging assistance. And because this will involve tax planning, be sure to consult your tax advisor.
At Butcher Joseph Hayes, we’ve advised on these types of transactions in a multitude of scenarios. They include, but are not limited to, family-owned companies selling to ESOPs for succession and estate planning, private equity firms selling portfolio companies to ESOPs, management buyouts by key executives combined with an ESOP sale, recapitalization of existing ESOP-owned companies (to recharge the capital structure) and, in the appropriate circumstance, selling a company owned by an ESOP or even taking it public. Our ESOP experts have more than 25 years of experience in dealing with these highly specialized transactions.
As always, thank you for reading.
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