Employee stock ownership plans (ESOPs) provide a number of benefits to selling shareholders, employees and the sponsoring employers. For selling shareholders, one benefit is the opportunity to elect to defer the tax on any gain realized on the sale of their stock to the ESOP. The following discussion provides an overview of this tax deferral opportunity and the factors to consider when choosing whether to make the election.
1. What is IRC section 1042?
Internal Revenue Code section 1042 allows qualifying individuals, partnerships, estates and trusts to elect not to pay income tax on the recognized capital gains from the sale of equity in a non-publicly traded C corporation to an ESOP. To encourage meaningful employee ownership, a minimum of 30% of the company’s stock must be owned by the ESOP immediately after the sale.
2. What are the general requirements for section 1042 tax deferral?
Tax deferral is allowed under section 1042 if all of the following apply:
- The selling shareholder elects this treatment upon the sale of non-publicly traded C corporation stock to an ESOP.
- The ESOP owns at least 30% of the C corporation following the sale.
- The proceeds from the sale are reinvested in qualifying replacement securities during the period starting three months prior to the sale and ending 12 months following the sale.
In addition, the stock sold must have been held for at least three years and not acquired through an employer plan or option agreement.
Beginning in 2028, S corporation stock may also qualify for this tax deferral election, but only for up to 10% of the gain rather than for the 100% of the gain allowed for C corporation stock.
3. What is the value of tax deferral?
If a shareholder elects to defer tax on the stock sale, the basis in the stock is carried over to a portfolio of replacement securities and the gain is recognized in the future when the replacement securities are disposed.
The deferral is generally a temporary benefit, and the value is equal to the after-tax growth in the original tax liability deferred. However, the gain (including the deferral) on any portion of the portfolio held until the selling shareholder’s death could permanently escape income taxation. The estate tax is separate from income tax and may still apply to the estate value upon death; section 1042 is specific to income tax.
4. What is an example of the value of a 1042 tax deferral?
Joe owns 40% of a C corporation’s stock, which he purchased in 2005 for $100,000. Today, Joe’s stock is worth $2 million. If Joe sells his stock in a taxable sale, he will pay capital gains tax on $1.9 million of appreciation, or roughly $380,000, leaving him with a portfolio of securities worth $1.62 million. However, meeting the requirements of section 1042 and making the election would defer the $380,000 in tax and provide him with a portfolio of $2 million.
If Joe makes the 1042 election and sells the replacement securities in five years, when they are worth $2.5 million, he will have a $100,000 basis in the securities (the basis he carried over from his C corporation stock that was sold to the ESOP) and a gain of $2.4 million. Tax on this gain would be $480,000, netting Joe $2.12 million at the end of five years. Of course, Joe would need to compare that value to the after-tax proceeds if he had continued to own the C corporation stock for the five years and not sold it to the ESOP or had not made the 1042 election or qualified reinvestments.
Alternatively, if Joe still holds the replacement securities at his death, income tax would never be paid on the $1.9 million of original appreciation or on the increase in value to his date of death. The same would be true if he had continued to own the C corporation stock and not sold it to the ESOP.
5. What factors should be considered prior to electing a 1042 tax deferral?
The maximum price an ESOP can pay for stock is fair market value, which must be set by an independent third-party appraisal. This appraisal is an independent opinion of the price an unrelated buyer would agree to pay when neither buyer nor seller is compelled to enter into the transaction and both parties have knowledge of the relevant facts. Another consideration is that a newly formed ESOP often lacks the cash needed to make the acquisition, requiring the seller to either offer seller financing—and remain on the hook for business operations—or decrease the valuation to reduce the debt needed.
Third-party transactions often result in a purchase price that exceeds an independently appraised value. This can be due to synergies, a company-specific attribute or another factor leading the buyer to drive up value. If such a buyer exists, the fair market value that an ESOP can pay may be less than what that buyer is willing to offer.
It is not uncommon for an ESOP-owned company to acquire a non-ESOP-owned company and use the 1042 election as a negotiation tool. The ESOP-owned company may attempt to assign value to the tax deferral to make its purchase offer look better or enable a lower purchase price that still matches other purchase offers.
Shareholders should generally base decisions about business sales on after-tax rather than pre-tax cash flows—a strategy that is even more important when considering a 1042 election. After-tax flows help paint a complete picture that incorporates all relevant factors, including individual tax attributes such as capital loss carryforwards.
Generally, calculating after-tax cash is a complex but static process. You identify the different tax rates that will apply to the different types of income and then do the math. However, when considering a 1042 election, there is more at play: evaluating a static calculation against the ability to increase the yield and the return by investing more dollars. The calculation must consider the potential future growth of these additional dollars as well as the investment horizon and potential future capital gains rates.
Generally, the longer replacement securities are held, the more valuable the tax deferral becomes. Two major drivers in the length of holding are:
- The ability to reinvest proceeds up front
- The need to sell the reinvested portfolio for cash to sustain lifestyle or rebalance the portfolio down the road
Every dollar not reinvested in qualified securities carries with it a dollar of gain, up to the total amount of original gain. So taxpayers planning to not reinvest the proceeds from the sale within the 15-month replacement period may not benefit as they expect from this election.
Other shareholders may want to make the original investment but down the road need the cash to rebalance their portfolio, sustain their lifestyle, take a vacation or purchase that second home they had always wanted. This will shorten the length of the deferral, and reduce the potential return, by triggering the gain and tax in the securities sold.
6. How can ESOP shareholders maximize the tax benefits of a 1042 deferral while managing the associated risks?
To avoid selling replacement securities, shareholders making 1042 elections will often take out a margin loan by borrowing with the portfolio as collateral. This approach can allow the shareholder to live their life as they desire while still avoiding taxation on the original gain and future appreciation—but it comes with risks.
The interest rate on a margin loan generally floats with the market. Rather than being locked, the loan’s interest rate will increase when interest rates rise.
Making money in investing generally requires you to buy low and sell high. Margin loans are often available for only a certain percentage of the value of your portfolio. When the market goes down, the value of collateral decreases and can require you to sell securities to pay down the loan. This creates a scenario where you are selling in a down market, triggering the deferred gain and not capitalizing on your goal of buying low and selling high.
Anytime taxation of income is deferred, there is a risk that tax law changes may increase the amount of tax due when the income is triggered—and a 1042 election is not immune to this risk. Congress could increase the capital gains rate, increasing any tax that may be due upon disposal of replacement securities. Alternatively, the step up in basis at death that is currently available may be eliminated, leaving someone who was planning to entirely avoid taxation stuck paying tax on the gain. However, law changes may also benefit taxpayers—for example, through a decrease in capital gains rates or estate tax rates, or an increase in lifetime exemptions.
The time frame and variables associated with evaluation of the 1042 election can often make it hard to quantify the value that the election will provide. Getting to a meaningful answer can require collaboration with tax advisors, investment advisors and attorneys as you plan for the rest of your life and the best way to ensure your family legacy. The decision will still likely be fraught with ambiguity, requiring you to make an informed but not definitive decision.
7. Who should consider tax deferral on a sale to an ESOP?
The first consideration in making a 1042 election is whether the business is a good candidate for implementing an ESOP, if it does not already sponsor one. A good ESOP candidate is generally a profitable, closely held business of almost any size with strong management, employee performance and market position.
Because the company will maintain the ESOP after the selling shareholder exits, the management team and owners need to be comfortable with the ESOP. After the company decides to sell to an ESOP, each individual shareholder must decide whether to make a 1042 election.
The decision of whether to make a 1042 election can be complex, with many variables at play. Assigning an absolute value to this election can be virtually impossible, as it would require foretelling the future. However, in the right situation, with the right planning up front, the election and an ESOP transition can help employers maintain their legacy, both with the employees that helped build the business and with their family.
