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Section 1042: Sale of a Business to an ESOP

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Section 1042: Sale of a Business to an ESOP

June 4, 2014

(2)

Overview

Qualified Replacement Property

Investment Strategy

Questions

Table of Contents

(3)

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

(4)

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”

(5)

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

(6)

Illustration

Employer Bank

ESOP

Loan Guarantee and Loan Repayment

Plan Contribution

Shares $

Loan $$$

(7)

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

(8)

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

(9)

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

(10)

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

(11)

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”

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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

(13)

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)

(14)

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

(15)

Consequences of a Disposition

Gain Recognized

Only Taxed on Disposed Qualified Replacement Property

Remaining Qualified Replacement Property Not Taxed

(16)

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

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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

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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

(19)

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

(20)

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

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Borrowing against Floating Rate Notes

Seller

Reinvests Sales Proceeds FRN

Bank Pledged as

collateral Purchases

Mutual Funds Real Estate REITS

Municipals

U.S. Governments

(22)

Borrowing against Floating Rate Notes

Seller

Reinvests Sales Proceeds FRN

Bank Pledged as

collateral Purchases

Mutual Funds Real Estate REITS

Municipals

U.S. Governments Partnership interests

Qualified Replacement

Property

(23)

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

(24)

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

(25)

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

(26)

Compliance Requirements

Statement of Election

Statement of Purchase

Employer Consent to Excise Taxes

(27)

Conclusion

Section 1042

• Opportunity for tax-free conversion of closely-held stock into diversified portfolio

Technicalities Abound

Private Letter Rulings Establish the Rules

(28)

QUESTIONS?

(29)

THANK YOU!

(30)

Seminar Survey—Sale of a Business to an ESOP

Your opinions and suggestions are extremely valuable to us. Please take a few minutes to respond to these questions so that we may improve future seminars. Thank you for your time and comments.

1. How useful was the seminar to you? Please circle one.

not useful somewhat useful very useful 1 2 3 4 5 2. Was the objective of the seminar met?

no not sure yes

3. The presentation and presentation materials were:

too detailed not detailed enough appropriate 4. The presentation was:

too long too short the right length 5. The presentation skills of the presenters were:

Poor fair excellent 1 2 3 4 5 6. Would you recommend this seminar to an associate or friend?

no not sure yes

7. The most convenient time for a seminar is:

morning mid-day evening 8. The teleconference method of delivery was:

Poor fair excellent 1 2 3 4 5 9. What other seminar topics are of interest to you?

_____________________________________________________________________________ 10. Any additional comments?

_____________________________________________________________________________ 11. I am interested in receiving more information about family governance strategies.

Name: ________________________________________________________________________ Address: _______________________________________________________________________ _____________________________________________________________________________ 12. The following person might also be interested in receiving information about family governance strategies.

Name: ________________________________________________________________________ Address: _______________________________________________________________________ _____________________________________________________________________________ MANDATORY ATTENDANCE RECORD FOR CONTINUING EDUCATION CREDIT

Please complete this section of the form if you are interested in obtaining CE Credit. Approval is pending for CFPs, CTFAs and attorneys in applicable states.

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Disclosure

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.

Pursuant to IRS Circular 230, we inform you that any tax information contained in this communication is not intended as tax advice and is not intended or written to be

used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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