1042 Rollovers: Deferring Capital Gains on ESOP Sale Proceeds

Capital gains taxes can squeeze even the most generous liquidity event. A business owner can expect a 20–38% post-tax reduction in sale proceeds 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 provides shareholders with 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
• Corporate floating-rate notes
• Certain real estate investments

US Treasury Bonds and mutual funds are not eligible for QRP reinvestment. Selling shareholders have 12 months post-closing to reinvest their proceeds in a QRP.

Eligibility

To qualify, sellers must own their company shares for at least three years before completing an ESOP sale. Following the transaction, an employee trust must hold at least 30% of the company's stock. Additionally, sellers and their immediate family members cannot participate in the employee stock ownership plan.

Corporate Structure and 1042 Exchanges

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.

Purchasing QRPs on Margin

Many qualified replacement properties can be purchased on margin. The portion of a QRP investment financed by a monetization loan is treated the same as the original ESOP sale proceeds. This enables selling shareholders to access the majority of their newfound liquidity without incurring capital gains burdens. These funds can be used at the selling shareholder's discretion and reinvested in more active strategies.

Trading QRPs

If an investor sells their qualified replacement property, capital gains taxes on the initial ESOP transaction can be triggered and owed. However, if an investor holds a QRP until death, the investment receives a step-up in basis and can then 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.

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 ESOP benefit in 1986. It has since expanded the tax incentive multiple times through bipartisan legislation. Lawmakers passed the most recent amendment to 1042 eligibility in December 2022.

Additional tax code changes may occur during the life of a qualified replacement property investment. Nonetheless, a QRP investment should still offer tax-advantaged upside to selling shareholders compared to a capital gains tax payout.

That's a comforting calculation 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-à-vis other M&A transactions.