Advantages and Disadvantages of a 1042 Election
Internal Revenue Code Section 1042 is an elective provision that allows individuals, partnerships, trusts, and estates that sell shares of stock of a C corporation to an ESOP to choose not to recognize the long-term capital gain realized in connection with the sale for federal income tax purposes. Instead, the recognition of the capital gain is deferred until a future point in time, or even eliminated. Section 1042 treatment must be properly elected by the taxpayer within the time frame for filing the tax return for the year of the sale to the ESOP. The basic requirements for making the 1042 Election include the following:
- The company sponsoring the ESOP must be a C corporation. (In some cases it is actually worth converting from an S corporation to a C corporation, even though you cannot convert back for five years.)
- Immediately following the sale to the ESOP, the plan must own at least 30% of the company’s stock.
- The seller must, within 12 months, invest the proceeds of the sale in “Qualifying Replacement Property” (QRP) --- U.S. domestic stocks and bonds. (Mutual funds, real estate, and certain other investments are not allowed.)
- The seller must have held stock in the C corporation for at least three years prior to the sale.
- Excluded from sharing in the eventual allocation of these shares, during the “non-allocation period”, are
- The seller,
- Certain members of his family (spouse, children, grandchildren, and parents), and
- Every shareholder owning over 25% of any class of the company’s stock.
The 1042 Election can have significant tax advantages for the seller:
- First, the capital gains tax that would be paid due to the sale of the company stock can be postponed. The basis in that stock becomes the basis in the Qualifying Replacement Property. The capital gains tax is not paid until those securities are sold.
- Second, for any replacement property still owned by the seller at his or her death, there is a step-up in basis to the market value at that time, thus eliminating the capital gains tax altogether.
- Assume an owner's basis in his company is $1,000,000. The market value of the company is $4,000,000 when he sells 100% of the company to a new ESOP.
- Unrealized appreciation at time of sale to the ESOP is $3,000,000.
- Assuming a combined (federal and state) 25% capital gains tax rate, the tax would be $750,000 if there were no 1042 election.
- Assume the seller makes a 1042 election (which must be filed with his personal tax returns) and all proceeds are invested into Qualifying Replacement Property.
- The basis of the new securities is deemed to be $1,000,000.
- Twenty years down the road, assume the Qualifying Replacement Properties have grown to $11,000,000. (That’s appreciation of a little over 5% per year.) The unrealized appreciation would be $10,000,000. If the securities were sold at that time, the 25% capital gains tax would be $2,500,000.
- Assume the individual dies 20 years from now, still holding the replacement properties. Then the basis is stepped-up to the $11,000,000 fair market value at death. Consequently, the $2,500,000 capital gains tax disappears completely.
Advantages of a 1042 Election
1) A seller can defer capital gains.
2) If the QRP has not been sold by the time the seller dies, there is a step-up in basis, thus eliminating capital gains altogether.
3) Even if not deferring capital gains until death, the seller gets to choose the year in which he sells the QRP, thus having some control over the timing of the taxes.
4) A partial 1042 election is also permitted if the seller wishes to defer capital gains on only part of the proceeds of his sale.
5) Some brokerage firms and financial institutions are willing to lend around 70% on a portfolio including equities. Theoretically a person could put the sale proceeds into a QRP portfolio and then borrow up to 70% of that amount to generate a retirement income, paying only interest on the debt each year. At death, when the capital gains have been eliminated, the portfolio can be partially liquidated in order to pay off the entire debt.
Disadvantages of a 1042 Election
1) If the employer is an S corporation, then it must first convert to a C corporation in order to use a 1042 election.
2) In order to qualify, the proceeds from the sale must be available within 12 months of the sale to the ESOP. So in order to have all the proceeds qualify, the seller must get a lump sum, instead of taking a personal note over several years. This may require involving a lender.
3) If the intent is to only buyout one shareholder, who happens to own less than 30% of the company, then you can’t meet the requirement that the ESOP must own at least 30% of the company right after the sale.
4) In order to qualify for the delayed capital gains, the sale must be directly to the ESOP, as opposed to retiring some shares and selling only part to an ESOP. There are times when a large sale to an ESOP creates problems with the debt service. In some cases it could require such large company contributions to the ESOP that those contributions exceed the deduction limits or the individual limits on what can be credited to any one participant in a given year.
5) Deferring capital gains can be risky since capital gains rates could go up in the future.
6) In order to purchase QRP, the seller must not buy mutual funds or foreign investments. The seller is limited to U.S. domestic stocks and bonds.
7) If the seller plans to be an employee after the sale, but makes a 1042 election, then he cannot participate in the ESOP allocation of the shares he is selling to the ESOP. (Family members would also be precluded from participating in those shares inside of the ESOP.)
8) Prior to the 2009 recession, a seller could purchase long-term floating rate, AAA-rated corporate bonds at one rate, and then borrow against them at a rate that was only slightly higher than the bond rate. The lender was willing to lend an amount equal to 90% or more of the value of the bond. However, interest rates now are not that attractive. In other words, it can be cost prohibitive to invest all the proceeds in a long-term AAA corporate bond and borrow against it to live off the borrowed amount, while planning on keeping the QRP until death, in return for a step-up in basis.
9) If borrowing against a QRP portfolio in order to generate retirement income, then the seller needs to consider some worse case scenarios involving large drops in the stock or bond markets.