Capital gains taxes can squeeze even the most generous liquidity event. A business owner can expect a 20-35% 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 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 a 1042 rollover, 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 Treasuries and mutual funds are not eligible for QRP reinvestment.
Who can take advantage of a 1042 rollover?
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 family, cannot participate in the employee stock ownership plan.
Corporate structure also matters.
For a seller to take full advantage of a 1042 rollover, their company must close its ESOP transaction as a C corporation. While S corp 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 QRPs cannot be actively traded.
If QRP investments are sold during a selling shareholder’s lifetime, capital gains taxes on the initial ESOP sale can be triggered and owed. But if a QRP 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 rollovers have clear estate planning benefits.
Many QRPs can be purchased on margin.
The portion of a QRP 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 taxes. 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 tax benefit in 1986 and has since expended the incentive multiple times, through bipartisan legislation. The most recent amendment 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 a QRP 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 comforting calculus for owners of privately-held businesses who aspire to have meaningful, tax-advantaged liquidity events and diversification opportunities. As they say, "It's not what you make, it's what you keep."