1042 Rollovers – More Meaningful than Ever

Proposed tax code changes always dominate headlines. When talk of corporate, personal, and capital gains hikes echo throughout Capitol Hill, it creates a fog for business owners considering a liquidity event.

Closely-held businesses can’t relay on transaction timing to get ahead of a potential tax hike. But when shareholders sell equity to an employee stock ownership plan, they can utilize a unique mitigation strategy:  the 1042 rollover.

ESOP sales can blunt the impact of capital gains taxes.

Unlike a private equity or third-party sale, an ESOP transaction affords selling shareholders the opportunity to defer and potentially eliminate capitals gains taxes on the sale proceeds. Section 1042 of the Internal Revenue Code outlines the requirements and mechanics behind this tax mitigation strategy, known as a 1042 rollover.

1042 rollovers are nuanced, but there are a few key rules.

1. The ESOP sponsor must close its sale as a C corporation

2. The ESOP must own at least 30% of the sponsor’s stock

3. Shares were held by the seller for at least three years prior to sale

4. Selling shareholders, and their immediate family, cannot participate in the ESOP plan

5. Sellers have 12 months to reinvest their sale proceeds in a Qualified Replacement Property (QRP)

6. QRPs are securities issued by US operating corporations, with certain exceptions; REITs, US Treasuries, and mutual funds do not qualify

How can QRP investors mitigate tax liabilities?

It is important to note that most QRPs cannot be actively traded. If securities are sold during the 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.

It should be noted that the Biden Administration has considered eliminating the step-up in basis benefit. While this could reduce 1042 rollovers’ value proposition, a QRP investment would still offer tax-advantaged upside, compared to a capital gains tax payout. And, of course, further positive or negative tax code changes during the life a QRP investment are possible.

1042 rollovers have clear estate planning benefits, but this strategy often begs a common question among selling shareholders:  what if I need or want to access my gains now?

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.

ESOPs and 1042 rollovers have enduring Congressional support.

Although it’s hard to predict the future – let alone pending tax code changes – the major ESOP and 1042 benefit reductions are unlikely. Employee ownership enjoys broad bipartisan support dating back to 1974, when ESOPs were codified in ERISA, the landmark Employee Retirement Income Security Act.

While you can’t count on a fixed, national tax policy, ESOPs and 1042 rollovers are likely here to stay. That should offer some comfort to owners of privately-held businesses who aspire to have a meaningful, tax-advantaged liquidity event and diversification opportunity.

As they say, "It's not what you make, it's what you keep."