Can selling my company to an ESOP defer the capital gain?

What it is

An employee stock ownership plan is a qualified retirement plan that invests primarily in the employer's stock. Selling to an ESOP can provide a buyer for a closely held company while keeping the business independent and giving employees an ownership stake.

For owners of C corporations, §1042 adds a tax benefit: the capital gain on the sale can be deferred if the proceeds are reinvested in qualified replacement property, generally securities of domestic operating corporations.

What the law says

IRC §1042(a) provides that, if the taxpayer elects, buys qualified replacement property within the replacement period, and meets the requirements of §1042(b), long-term capital gain on the sale is recognized only to the extent the amount realized exceeds the cost of the replacement property.

Section 1042(b) requires that the sale be to an ESOP or eligible worker-owned cooperative; that the plan own at least 30% of each class of outstanding stock or of the total value of all outstanding stock immediately after the sale; that the taxpayer file a verified written statement of the employer consenting to the related excise tax rules; and that the taxpayer's holding period be at least three years at the time of sale. Section 1042(c) limits qualified securities to employer securities of a domestic C corporation that has no readily tradable stock, and defines the replacement period as beginning 3 months before and ending 12 months after the sale.

Treas. Reg. §1.1042-1T explains that the election is made by a statement attached to the return for the year of sale, filed by the due date including extensions, with notarized statements of purchase of the replacement property, and that the election, once made, is irrevocable.

Requirements and tests

All of the following must be met:

• The corporation is a domestic C corporation with no stock readily tradable on an established securities market.
• The securities were not received as a distribution from a qualified plan or through certain compensatory options or transfers.
• You held the stock at least three years at the time of sale.
• The ESOP owns at least 30% of each class of outstanding stock, or of total value, immediately after the sale, after applying the option attribution rule of §318(a)(4).
• The employer signs a written consent to the excise tax provisions.
• You buy qualified replacement property from 3 months before to 12 months after the sale.
• You make the election on a timely filed return, including extensions, with the required statements.

How it works

The ESOP trustee, advised by an independent appraiser, negotiates the purchase price, which cannot exceed fair market value. The ESOP often borrows to fund the purchase, and the company repays the loan through contributions to the plan.

You reinvest the proceeds in qualified replacement property: stocks and bonds of domestic operating corporations that meet the passive income limits, not securities of the company you sold. Gain is deferred to the extent of the reinvestment, and the replacement property takes a reduced basis equal to its cost minus the deferred gain.

When you later sell replacement property, the deferred gain attached to it is recognized. If you hold the replacement property until death, your heirs generally receive a basis equal to its fair market value under §1014, which means the deferred gain is not taxed to them.

State tax treatment may differ, so check your state's conformity. Texas has no individual income tax.

Risks and IRS scrutiny

ESOP transactions are regulated by both the IRS and the Department of Labor. Valuation is the most scrutinized issue, because an ESOP cannot pay more than fair market value. On the §1042 side, common errors include missing the replacement period, buying ineligible replacement property, failing to attach the notarized statements, and missing the 30% test. After the sale, allocations of the sold stock to certain family members and 25% shareholders are prohibited, with excise taxes under §4979A.

Who it is not for

The §1042 deferral is not available to S corporation shareholders or to owners of publicly traded companies. It is not for a seller who needs the proceeds in cash, because selling the replacement property triggers the deferred gain. It is not for a seller who has held the stock less than three years. And an ESOP sale is not for a company that cannot support the plan's repurchase obligations and ongoing administration.

How ebotCPA helps

We test the §1042 requirements, model the deferral against a taxable sale, coordinate the replacement property purchases and timeline, and prepare the election and statements. We work alongside the ESOP trustee, the appraiser, and ERISA counsel. We coordinate with your attorney, who drafts the legal documents.

Book a $497 Case Analysis to have Ebot Mbi, CPA, EA review your facts before you act.

Primary sources

1. 26 U.S.C. §1042. Sales of stock to employee stock ownership plans.

   “The taxpayer’s holding period with respect to the qualified securities is at least 3 years (determined as of the time of the sale).”

   Sets the election, 30% ownership, three-year holding period, employer consent, and replacement period requirements.

2. 26 U.S.C. §1042(c)(3). Replacement period.

   “the period which begins 3 months before the date on which the sale of qualified securities occurs and which ends 12 months after the date of such sale.”

   Defines the window for buying qualified replacement property.

3. Temp. Treas. Reg. §1.1042-1T. Questions and answers on §1042 sales.

   “Also, an election once made is irrevocable.”

   Explains how and when to make the election and the notarized statements of purchase.

4. 26 U.S.C. §1014. Basis of property acquired from a decedent.

   Generally gives inherited property a basis equal to fair market value at death.

5. 26 U.S.C. §4979A. Tax on certain prohibited allocations.

   Imposes an excise tax when stock acquired in a §1042 sale is allocated to prohibited persons.

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