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Section 1042 Capital Gains Tax Deferral

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Section 1042 Capital Gains Tax Deferral

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The benefits from an ESOP can provide meaningful value to the selling shareholder(s), the company and the employees participating in the Employee Stock Ownership Plan (ESOP). Tax issues should not drive the decision to sell a business, but once the decision is made, the tax benefits of the ESOP make it a viable alternative to selling to a strategic buyer. This presentation takes a close look at the IRC section 1042 capital gains tax deferral that applies when selling a business to an ESOP.

The benefits from an ESOP can provide meaningful value to the selling shareholder(s), the company and the employees participating in the Employee Stock Ownership Plan (ESOP). Tax issues should not drive the decision to sell a business, but once the decision is made, the tax benefits of the ESOP make it a viable alternative to selling to a strategic buyer. This presentation takes a close look at the IRC section 1042 capital gains tax deferral that applies when selling a business to an ESOP.

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Section 1042 Capital Gains Tax Deferral

  1. 1. Section 1042 Capital Gains Tax Deferral Why you should consider a 1042 election when selling your business
  2. 2. 2 WHAT IS THE SECTION 1042 TAX PROVISION? There are significant tax benefits for owners of privately held companies who consider selling their business to an Employee Stock Ownership Plan (ESOP) and elect to take advantage of the Section 1042 Capital Gains Tax Deferral. Section 1042 allows selling shareholders to defer capital gains taxes on shares they sell as long as certain requirements are met. The Section 1042 election is basically an exchange in that the seller is able to defer the proceeds from the sale of stock by reinvesting the process in similar assets. These assets are typically referred to as Qualified Replacement Property (QRP). WHEN IS SECTION 1042 APPROPRIATE? Section 1042 is most appropriate when the seller has the ability to utilize the sale proceeds or invest a portion of them in QRP without creating personal liquidity. The margin loan structure is one way to implement the structure while creating liquidity. In this situation, the seller has the ability to use a portion of the proceeds from the sale as collateral on a margin loan that allows them to meet the reinvestment requirement while generating significant liquidity.
  3. 3. 3 QUALIFIED REPLACEMENT PROPERTY (QRP) Qualified Replacement Properties (QRP) must be purchased within the 15 month period ending 12 months after the sale to an ESOP. The tax basis of the stock sold to the ESOP will carry over to the QRP. The seller currently owns shares of a U.S. operating company, and the sales proceeds must be used to purchase stocks or bonds of a U.S. operating company. Floating Rate Notes (FRN) are sometimes issues with tax opinions that state they qualified for a Section 1042 treatment. ELIGIBLE QRP NOT ELIGIBLE AS QRP • Common stock • Preferred stock • Convertible bonds • Corporate fixed rate notes • Corporate Floating Rate Notes (FRN) • Municipal bonds • US Government Bonds • Bank CDs • Mutual funds • REITs • Foreign Securities ELIGIBLE ISSUER MUST HAVE: • 50% or more of assets engaged in an active trade or business (no holding companies) • No more than 25% of income can be from passive sources (franchise fees, interest)
  4. 4. 4 BASIC REQUIREMENTS FOR SECTION 1042 ELIGIBILITY The company involved in the transaction is a domestic C Corporation. 30% or more of the company’s equity value must be sold to the ESOP. The seller must have held the stock for at least three years prior to the sale of an ESOP. The stock sold to the ESOP must be common stock or its equivalent. The investment in QRP must be made within a 15-month period beginning three months prior to closing and ending 12 months following deal close. The dollars invested in QRP do not have to be the actual sales proceeds, but may be a dollar amount equal to the amount of the proceeds on which the seller desires to defer capital gains taxes.
  5. 5. 5 PROS & CONS OF A 1042 ELECTION PROS OF A 1042 ELECTION • A seller can defer capital gains. • If the QRP has not been sold by the time the seller dies, there is a step-up in basis, thus eliminating capital gains. • The seller may choose the year in which (s)he sells the QRP, thus having some control over timing of the taxes. • A partial 1042 election is permitted if the seller wishes to defer capital gains on only part of the proceeds of the sale. CONS OF A 1042 ELECTION • If the employer is an S Corp, then it must convert to a C Corp in order to use a 1042 election. • In order to qualify, the proceeds from the sale must be available within 12 months of the sale to the ESOP. • In order to qualify, the sale must be directly related to the ESOP, as opposed to retiring some shares. • Deferring capital gains can be risky since capital gains rates could up in the future. • In order to purchase QRP, the seller is limited to U.S. domestic stocks and bonds. • If the seller plans to be an employee after the sale, but makes a 1042 election, (s)he can’t participate in the ESOP allocation of the shares.
  6. 6. 6 CONSIDERING A 1042 ELECTION? The sale of all or part of a C corporation to an ESOP may provide an opportunity for the seller to defer or eliminate capital gains taxes on the sale. Tax issues should not drive the decision to sell a business, but once the decision is made, the tax benefits of selling to an ESOP make it a viable alternative to selling to a strategic buyer. Structuring this type of a transaction requires planning and an advisor well versed in the requirements for successfully implementing these structures. ButcherJoseph has deep experience in structuring these transactions, making sure the guidelines and regulations are met, and that the business owner receives maximum value when selling all or part of their business. Download our complimentary white paper to take an in-depth look at the IRC section 1042 capital gains tax deferral that applies when selling a business to an ESOP.
  7. 7. 7 Should You Consider a 1042 Election? ESOP Tax-Deferred Rollover Interested in learning more about the Section 1042 Capital Gains Tax Deferral ? READ ONE OF OUR BLOGS BELOW IRC Section 1042 Capital Gains Tax Deferral Defer Long Term Capital Gains Taxes: Using a Margin Loan We can help you maximize your tax advantage - Let’s chat!

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