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1042 Rollovers: Deferring Capital Gains on ESOP Sale Proceeds
April 17, 2023 •Eitan Milstein
Capital gains taxes can squeeze even the most generous liquidity event. A business owner can expect a 20-38% haircut following a typical M&A transaction. That is, unless the buyer is an employee stock ownership plan (ESOP).
Section 1042 of the US Internal Revenue Code offers shareholders the opportunity to defer (and potentially eliminate) capital gains taxes on the sale of stock to ESOPs and eligible worker-owned cooperatives. To take advantage of this unique benefit, a seller must reinvest their sale proceeds in a qualified replacement property (QRP). Commonly known as either a 1042 rollover or a 1042 exchange, the strategy is similar to a 1031 exchange of real estate.
Qualified Replacement Property Reinvestment
QRPs are securities issued by US operating corporations (with some exceptions). These may include common stock, convertible bonds, corporate fixed rate bonds, and corporate floating rate notes. US Treasury Bonds and mutual funds are not eligible for QRP reinvestment.
Who can take advantage of a 1042 exchange?
To qualify, sellers must own their company shares for at least three years prior to completing an ESOP transaction. Selling shareholders have 12 months post-closing to reinvest their proceeds in a QRP.
Post-sale, an employee trust must hold at least 30% of the company's stock. In addition, sellers, and their immediate families cannot participate in the employee stock ownership plan.
An ESOP-owned corporation's structure impacts capital gains tax deferral opportunities.
For a seller to take full advantage of a 1042 rollover, their company must close its ESOP transaction as a C corporation. While S corporation shareholders are also entitled to a tax-deferral, QRP reinvestment is limited to 10% of their sale proceeds. The remainder is subject to standard capital gains taxes.
Most qualified replacement properties cannot be actively traded.
If QRPs are sold during an investor's lifetime, capital gains taxes on the initial ESOP transaction can be triggered and owed. But if a qualified replacement property is held until death, the investment receives a step-up in basis and can be sold without triggering taxes.
Gifts of QRPs, and transfers tied to divorces, also do not qualify as taxable dispositions. As a result, 1042 exchanges have clear estate planning benefits.
Many QRPs can be purchased on margin.
The portion of a qualified replacement property transaction financed by a monetization loan is treated the same as the original ESOP sale proceeds. This enables QRP investors to access the majority of their newfound liquidity without incurring capital gains burdens. This remainder can be used at the selling shareholder’s discretion, including reinvestment in more active strategies.
Congressional Support for 1042 Rollovers
It’s hard to predict future tax code changes, but Section 1042 is likely here to stay. Congress first codified the employee stock ownership plan benefit in 1986. It has since expended the tax incentive multiple times through bipartisan legislation. The most recent amendment was passed in December 2022.
It's important to note that the Biden Administration has considered eliminating the step-up in basis benefit, and additional tax code changes during the life of a qualified replacement property investment are possible. Nonetheless, a QRP investment should still offer tax-advantaged upside to selling shareholders, compared to a capital gains tax payout.
That's a comforting calculus for business owners seeking ESOP-led liquidity events and diversification opportunities. As they say, "It's not what you make, it's what you keep." The opportunity to defer or eliminate capital gains burdens on an employee stock ownership plan sale can give these strategies a unique leg up vis-a-vis other M&A transactions.