Under Section 1042, sellers to ESOPs are eligible to defer their capital gain through investment in Qualified Replacement Property (QRP). Sellers make reinvestments into QRP (typically stock and bonds of domestic companies) which is the vehicle to accomplish the tax deferral. The seller’s basis in the stock sold to the ESOP carries over to the QRP. The gain is then deferred until the QRP is disposed of, which would be a recognition event.
The Section 1042 tax deferral, which is specific to ESOP companies, can be very advantageous, especially in an environment of changing tax rates.
The IRS requirements for Section 1042 elections are very specific. It’s important for sellers to follow the steps below to make sure that these requirements are carefully addressed.
1.Make sure you meet the requirements for Section 1042 deferral.
- Sale of stock must be issued by a domestic C Corporation (In some cases it is worth converting from an S Corporation to a C Corporation, although you cannot convert back for five years)
- Holding period in stock must be at least three years
- After the sale, the ESOP must own at least 30 percent of the employer that sponsors the ESOP
- QRP must be purchased within the 15-month period that begins three months before and ends 12 months after the sale of the company stock to the ESOP
2.Know where, when, and how to make election.
The election should be attached to the seller’s tax return in the year the sale to the ESOP occurs. The election cannot be made on an amended tax return unless it is filed before the due date of the original tax return (including extensions).The election, along with a consent statement from the ESOP employer corporation, must be attached to the tax return. The election must contain specific information regarding the sale to the ESOP.
3.Verify that investments are QRP.
It’s important to verify that your investments are qualified replacement property. In particular, government bonds, mutual funds, real estate, and certain other investments are not permitted.Statements of purchase (SOP) for the QRP must be attached to the tax return. If the QRP is not purchased by the time of the election, it should be filed with the tax return for the subsequent year. Sellers have up to 12 months after the sale to the ESOP to buy QRP.Under the Regulations, the SOP must be notarized within 30 days of the purchase of the QRP. Temporary Regulation 1.1042-1T, A-3(b) relaxed that requirement, allowing the SOPs to be notarized no later than the time to file the tax return. Taxpayers may rely on the proposed regulations until guidance is issued in final regulations.
4.Lock in your tax deferral.
The following transactions involving QRP do not trigger gain recognition, based on the current law as of July 26, 2021 (this may be subject to change with Biden’s current tax proposals):
- Dispositions at death
- Dispositions by gift, including a charitable contribution and transfers to certain trusts
In an environment where we are facing possible changes to the capital gain tax rates, a Section 1042 tax deferral may become more advantageous. However, the election requires thorough and detailed documentation. In addition, management of your carryover basis in the QRP is required on an ongoing basis. Kreischer Miller’s ESOP Accounting services team can help you plan for a Section 1042 deferral and manage your compliance obligations.
If you would like to discuss your company’s ESOP strategy, contact us or click here to learn more about our services for ESOPs – including ESOP accounting, ESOP planning, and how business owners can use an ESOP as an exit strategy.
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