Section 1042: Sale of a Business to an ESOP
June 4, 2014
Overview
Qualified Replacement Property
Investment Strategy
Questions
Table of Contents
Section 1042: Overview
Taxpayer May Defer Recognition of Capital Gain on Sale of Company Stock to an ESOP
• Owner sells stock to ESOP
• Reinvests cash proceeds in “qualified replacement property” (QRP)
• Gain on sale deferred until disposition of QRP
Section 1042: Requirements
Important Highlights
• Taxpayer may defer recognition of capital gain on sale of “qualified securities” to an ESOP
• Taxpayer held “qualified securities” ≥ 3 years
• Taxpayer purchased “qualified replacement securities” 3 months before, or 12 months after, sale of “qualified securities”
• ESOP must own, after sale, ≥ 30% of each class, or 30% of total value, of all outstanding stock of company
• Taxpayer files election to defer gain on timely filed income tax return (plus extensions) for the year of sale of “qualified securities”
• Taxpayer must file “Statement of Purchase” of “qualified replacement securities”
Section 1042: How It Works
Employer Establishes an ESOP
Shareholder Contracts with ESOP to Sell Shares to ESOP
ESOP (via Company) Borrows Funds from Financial Institution
ESOP Uses Loan Proceeds to Buy Seller’s Shares
Employer Makes Contributions to ESOP to Pay Off Loan
Illustration
Employer Bank
ESOP
Loan Guarantee and Loan Repayment
Plan Contribution
Shares $
Loan $$$
Section 1042: Who Can Participate
Must Be Sale of Closely-held “C” Corporation Stock to ESOP
• S-corporations may not execute a Section 1042 rollover Selling Shareholder Must Be:
• Individual
• Trust
• Estate
• Partnership
• LLC (taxed as partnership)
Selling Shareholder Cannot Be a “C” Corporation
Qualified Securities Definition
Stock to Be Sold
• Employer securities issued by domestic “C” corporation
• Held by taxpayer at least three years
• Company has no outstanding stock readily tradable on established securities market within year before and after sale
− Must be closely-held stock
• Stock not received by taxpayer:
− In a distribution from a qualified plan, or
− Via exercise of NQSO, ISO or similar right granted to shareholder
30% Requirement
Does Not Matter How ESOP Accumulated Shares
Preferred Stock Not Included in Determining 30% Requirement
Sale of Stock to ESOP by Two or More Shareholders Can Be Considered As Single Sale for 30% Requirement
• Must be prearranged as single, integrated transaction
• 30% threshold satisfied if ESOP
− Acquires stock via contribution by corporation, or
− Sale by shareholders
Qualified Replacement Property
Stock to Be Purchased
• Seller must invest in qualified replacement property 15 months commencing three months prior to sale
Sale
3 months 12 months
Qualified Replacement Period
Qualified Replacement Property Definition
Stock to Be Purchased
• Any security
• Issued by domestic operating corporation (publicly traded or closely held)
− More than 50% corporation’s assets must be used in active conduct of trade or business
− May not have passive investment income in excess of 25% of corporation’s gross receipts for tax year preceding year in which replacement securities purchased
• Is not the corporation which issued the “qualified securities”
Qualified Replacement Property
Result
• Provides tax deferral on sale of business
• Converts investment in privately-held corporation to diversified portfolio of publicly-traded securities
• Gain subsequently recognized when there is a “disposition” of qualified replacement property
Qualified Replacement Property
What Qualifies As Qualified Replacement Property?
• Stock, stock rights, bonds, debentures, warrants, notes and certificates of U.S. operating companies or other evidences of indebtedness in registered form and with coupons attached
− May be securities of either publicly-traded or closely-held corporations
• May be used to bankroll new operating company
− Bonds may not be good because they may be callable
• Some financial institutions have developed long-term, non-callable bonds (with put protection) with floating interest rates to meet the qualified
replacement property definition (e.g., floating rate notes)
Qualified Replacement Property
What Does Not Qualify As Replacement Property?
• Mutual funds
• Real estate
• Real Estate Investment Trusts (REITs)
• Municipal bonds
• U.S. Government securities
• Partnership interests
• Certificates of deposit
• Securities of foreign companies
• Securities of sponsoring corporation
Consequences of a Disposition
Gain Recognized
Only Taxed on Disposed Qualified Replacement Property
Remaining Qualified Replacement Property Not Taxed
What Is a Disposition?
Sale of Qualified Replacement Property
• Controlled by client
Maturation of Qualified Replacement Property
• Determined by design of securities
Calling of Qualified Replacement Property by Issuer
• Determined by outside market forces
Seizure of Qualified Replacement Property by Judgment or Creditor
Investment Strategy
Invest So That Client Can Control Timing of Disposition
Buy and Hold Diversified Equities and High-quality, Non-callable Bonds of U.S. Operating Companies
Investment Strategy (cont.)
Equities
• Exclude callable, preferred stocks, common stock rights and warrants, and economically sensitive stocks
• Buy common stock in well-established companies with high market share and a commitment to grow earnings and dividend income
Investment Strategy (cont.)
Seek Securities with “Call Protection”
• More readily available with debt securities (e.g., floating rate notes (FRN))
• Floating rate notes
− Issued by Fortune 500 companies (e.g., GE Capital, McDonalds, Proctor & Gamble, Merck, UPS)
− Maturity of 40 to 60 years with “call protection” for 25 to 30 years at relatively high premium
− 30/90 day floating rate based on LIBOR commercial paper plus spread (e.g., 25 basis points)
• Strategy
− Borrow against FRN (75% to 90% value) and invest loan proceeds in diversified portfolio, including assets that do not meet QRP definition
• Variable loan interest rate based on LIBOR plus spread
Investment Strategy (cont.)
Floating Rate Notes
• Invest proceeds in floating rate notes (FRN)
• Floating rate notes meet definition of qualified replacement property
• Borrow against FRN
• Loan repaid from either:
− Gain on investment of loan proceeds, or
− At death when FRN receives step-up in basis, eliminating any gain
• Reinvest loan proceeds in any investment
− May be invested in assets that do not meet definition as qualified replacement property
Borrowing against Floating Rate Notes
Seller
Reinvests Sales Proceeds FRNBank Pledged as
collateral Purchases
Mutual Funds Real Estate REITS
Municipals
U.S. Governments
Borrowing against Floating Rate Notes
Seller
Reinvests Sales Proceeds FRNBank Pledged as
collateral Purchases
Mutual Funds Real Estate REITS
Municipals
U.S. Governments Partnership interests
Qualified Replacement
Property
Floating Rate Notes
Characteristics
• High credit quality (AAA/Aaa or AA/Aa rating)
• Principal stability—interest adjusts monthly so principal value remains stable
• Interest rate adjusts to reflect changes in credit quality
• Limited risks
− Margin call—value does not fluctuate due to variable interest rate allowing maximum margin loan borrowing
− Maturation—40- to 60-year maturity
− Call—first call date is 25 to 30 years
− Liquidity—investor may put notes to issuer in tenth year and every three years thereafter
Floating Rate Notes
Advantages
• Generate liquidity
− Borrow up to 90% face value of FRN
• Minimize risk
− Little risk of decline in market value of note due to floating interest rate
− However, value may decline due to decrease in rating or issuing company
• Maximize tax deferral
− Buy FRN not likely to mature for long period of time Disadvantages
• Negative and variable cash flow
− Low interest rates or decline in credit rating may result in net interest payment as interest expense exceeds interest payment on FRN
• Liquidity and investment risk
Other Considerations
Cost Basis of Closely-held Stock Becomes Basis of Qualified Replacement Property
Tax Can Be Avoided If Replacement Property Held until Death
• Stock receives step-up in basis
Replacement Property May Be Donated to, and Sold By, Charitable Remainder Trust Income Tax Free
Compliance Requirements
Statement of Election
Statement of Purchase
Employer Consent to Excise Taxes
Conclusion
Section 1042
• Opportunity for tax-free conversion of closely-held stock into diversified portfolio
Technicalities Abound
Private Letter Rulings Establish the Rules
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This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of
publication. However, this material is not intended to be a full and exhaustive
explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation.
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