1042 Gain Rollover
Under section 1042 of the Internal Revenue Code (the “Code”), an owner of a closely held C corporation (but not an S corporation at this time) can defer capital gains taxation on stock he or she sells to an ESOP if (1) the ESOP owns 30% or more of each class of outstanding stock or of the total value of all outstanding stock, excluding nonconvertible, nonvoting preferred stock; and (2) the seller reinvests (“rolls over”) the sale proceeds into qualified replacement property (stocks or bonds of domestic operating companies) during the period from three months before to twelve months after the sale. The price an ESOP pays in such transactions is based on a valuation by a qualified, independent appraiser.
The money “rolled over” into replacement property does not need to be the actual proceeds from the sale, but rather can be an equivalent amount of money from another source. Any or all of the proceeds can be rolled over; the seller(s) will simply pay taxes on the rest. Two or more owners may combine their sales to meet the 30% requirement if the sales are part of a single, integrated transaction. It has become increasingly common in 1042 transactions for sellers to facilitate the transaction by pledging part or all of their replacement property as collateral for the loan to finance the ESOP’s purchase of stock, especially in companies with limited assets or with substantial debt.
None of the shares sold to the ESOP in a 1042 transaction may be allocated to ESOP accounts of the seller, certain relatives of the seller (ancestors, siblings, the spouse, or lineal descendants), non-selling shareholders holding more than 25% of company stock, or family members of the more-than-25% shareholders if they own stock by attribution (e.g., spouses). (This restriction does not apply to ESOP stock not purchased in the rollover transaction.) There is one exception: lineal descendants of the selling shareholder(s) may be allocated a total of 5% of the stock, provided that the lineal descendants are not treated as more-than-25% shareholders by attribution.
There are other requirements for the section 1042 rollover; for example, the selling shareholder(s) must have held the stock for at least three years before the sale and cannot have received the stock through exercising stock options or certain employee stock arrangements under section 83 of the Code. If the ESOP disposes of the shares within three years after the sale, the employer generally must pay a 10% excise tax on the proceeds from the disposition.
Sellers using the 1042 rollover often avoid taxation completely by retaining the replacement property until death, at which time the property transfers to their heirs with a stepped-up basis.