The 1042 ESOP (Employee Stock Ownership Program) under Internal Revenue Code allows the shareholders to exchange their interest in a private company. The capital gains on eligible stocks sold on ESOP can be deferred with a private company for the portfolio of Qualified Replacement Property.
Qualified Replacement Property, abbreviated as QRP, includes convertible bonds of the operating companies. They could be equity or debt. The operating companies have to have:
- At least 50% of assets that are used in conducting active trade.
- Only up to 25% of the gross receipts should be from the passive source.
Here is a list of qualified replacement property stocks:
- Common Stocks
- Preferred stocks
- Corporate fixed-rate bonds
- Convertible bonds
- And Corporate Floating Rate Notes (FRNs)
Summary Requirements
Several requirements need to be met for the sale of any stock to qualify as 1042 exchange qualified replacement property rollover:
- The taxpayer must be an individual, a trust, a partnership, or an underwriter selling securities.
- Should meet the tax filing requirements.
- Hold stocks in corporations that are eligible and comply with requirements.
- The seller must have held the stock for a minimum of 3 years.
- The Employee Stock Ownership program must own a minimum of 30% of the total stock directly after its sale.
- The seller has a total of 15 months to invest the proceeds into the qualified replacement property. Three months prior to the sale and the remaining 12 months immediately after the ESOP transaction.
If the reinvesting amount exceeds the proceeds, then the source of that money could be anything other than the sale. However, the seller does not need to reinvest all the proceeds. If he chooses to reinvest less than the sale price, he is obliged to pay tax on the remaining amount. To comply with the 30% stock-owning requirements, two or more sellers combine their sales. The only requisite for this is that all the sales should be a part of a single transaction.
It should be noted that the sponsor company needs to be a C corporation to qualify for the 1042 rollover. Additionally, the shares sold to ESOP are not allocated to the ESOP account of the seller or any relative and any more than -25% shareholder.
Advantages of 1042
- The Capital gains tax is deferred for the period that the shareholder holds the QRP (Qualified Replacement Property).
- Section 1042 of the Internal Revenue Code is a way to provide beneficial tax treatment when they resell the stock on ESOP.
- Deferring of the long-term capital gains allows the investment of full transaction proceeds on QRPs.
- The long-term capital gains are only recognized when the QRP securities liquidate. If the QRP does not liquidate and ends up becoming an asset of the seller’s estate, then its basis is stepped up. Additionally, it avoids capital gains completely.
- The seller gets to choose the year of sales of the QRPs when there are no deferring capital gains until death.
- Some financial institutions and brokerage firms lend approximately 70% of the QRP portfolio, including equities. Therefore, a person can use the proceeds to generate retirement money. This way, he only has to pay the interest on debt every year.
At death, the portfolio can be partially or fully liquidated to pay off the remaining debt amount.
Disadvantages of 1042
- A company has to convert to a C corporation which is irreversible for the next five years.
- The proceeds from sales have to be available within a period of 12 months from the date of the ESOP transaction.
- To get all the proceeds qualified, the seller has to have a lump sum amount, which often means involving a lender.
- Even if the intent is to buy out one shareholder, he must own at least 30% of the company, which is not the case in many companies. Hence, they do not meet the requirements set under 1042.
- The seller must refrain from buying foreign investments and mutual funds—the market limits to U.S domestic stocks and bonds for the seller.
- The capital rates could go up in the future; hence deferring capital gains can prove risky.
Related Terms – qualified replacement property, 1042 exchange qualified replacement property, list of qualified replacement property stocks.
