For business owners who have devoted their time and resources over the years to building up their business, their company is likely their most valuable and prized asset. If they are interested in expanding their portfolio or retiring completely, they will need to explore the options available to them to divest their interests in the company. Given the intriguing financing options and tax benefits available through Employee Stock Ownership Plans (ESOPs), these structures are increasingly popular among selling a shareholders.

“Section 1042 allows shareholders to defer taxation on capital gains.”

When selling company stock to an ESOP, the Internal Revenue Code Section 1042 allows the shareholders of a closely held C corporation to defer taxation on all or a portion of the sale proceeds if the funds are invested in qualified replacement property (QRP). Once the QRP is liquidated in the future, any capital gains will be recognized at that time. The favorable tax treatment often makes an ESOP a very attractive option to selling shareholders.

For the sale to meet the established criteria for a 1042 rollover, certain factors must be met. The qualified securities must be sold to either an ESOP or a worker-owned cooperative. The selling shareholder must have held the stock for at least three years to qualify. Following the sale to the ESOP, the plan must own at least 30 percent of each class of stock or the total value of all outstanding stock of the corporation. In addition, the seller must reinvest the proceeds into the QRP within 12 months following the sale to the ESOP.

Interested in learning more about the Section 1042 Capital Gains Tax Deferral? Flip through the SlideShare below: 

Additional benefits

While the Section 1042 exchange offers immediate tax advantages, there are additional tax and estate planning benefits to owners of C-Corp companies who pursue an ESOP transaction. For instance, if the selling shareholder dies before liquidating the QRP, thereby leaving the funds as an asset of the estate, the property gets a stepped-up basis and can avoid capital gains all together. The seller also has flexibility in determining when to sell the QRP, which can be strategically planned to maintain more control over the property’s tax status, depending on the year’s tax schedule.

Selling shareholders may also have an opportunity to borrow money against the QRP. Some brokerage firms and financial institutions will permit the seller to use the equity in their financial portfolio as collateral. The seller can then use those funds and only pay the interest on the loan. Following the seller’s death, the remaining funds invested as QRP can be liquidated and subsequently used to pay off the outstanding loan.