Shareholders of closely held C corporations can currently sell stock to an employee stock ownership plan (“ESOP”) in a tax deferred “rollover” transaction under Section 1042 of the Internal Revenue Code of 1986, as amended (the “Code”). As long as the requirements of Code Section 1042 are satisfied, the selling shareholder can elect (the “1042 Election”) to defer capital gains taxes by reinvesting the proceeds into qualified replacement property (“QRP) – securities of domestic operating corporations. Investing in securities of international corporations or mutual funds will not constitute QRP. By making a valid 1042 Election, the selling shareholder defers capital gains, and the associated federal taxes, until the QRP is sold. However, if the QRP is held until death, capital gains, and the associated federal taxes, are forever eliminated. These tax benefits can make ESOP transactions an attractive exit strategy for shareholders of closely held C Corporations.
For example, if Shareholder X sells a sufficient amount of stock (at least 30% of his stock or at least 30% of value of the company) to an ESOP for $20 million and elects Code Section 1042 treatment by reinvesting the proceeds in QRP within the applicable time period (generally 12 months from the date of sale), he will avoid having to currently pay $4 million in federal capital gains tax (20% of $20 million) with respect to such sale. This example assumes that Shareholder X’s basis in the stock is zero. Note, the savings in capital gains tax can exceed 20% if the state of Shareholder X also exempts the sale and reinvestment into QRP from state capital gains tax. If Shareholder X holds onto the QRP until death and his estate disposes of the QRP, the estate will have no federal capital gains tax exposure because the estate takes the QRP with a stepped up basis equal to $20 million. Obviously, if the estate sells the QRP at an amount in excess of $20 million, the excess of the sales price above the estate’s $20 million basis would be subject to federal capital gains tax.
Another requirement of a valid 1042 Election is that the shareholder must have held the stock for at least three years before selling it to an ESOP. Tacking is permitted in the computation of the three-year holding period. As long as the shareholder acquired the stock in a manner that resulted in a carry over basis (such as being gifted stock), such shareholder can count the prior holding period in determining if the required three year holding period has been met. For example, if Shareholder Y was gifted 100 shares of stock a day before he sells such stock to an ESOP, Shareholder Y will be allowed to make a 1042 Election as long as the donor had held the stock for at least three years and as long as the other 1042 Election requirements are satisfied.
As outlined above, 1042 Elections provide a tax friendly incentive for business owners to transition their ownership interests in a corporation to an ESOP. Unfortunately, under current law only owners of subchapter C corporations can effectuate a 1042 Election. This means that S corporation shareholders have to either (i) convert to a C corporation (which may trigger negative tax consequences), or (ii) pay capital gains tax when and if they sell their corporate stock to an ESOP. Such restrictions may in fact impede the ability of the owner of an S corporation to sell his stock to an ESOP.
There is proposed federal legislation that would permit shareholders of S corporations to make a 1042 Election. This proposed legislation has existed for some time, but has yet to be enacted into law.
It is possible that the new administration under President Donald Trump may prove beneficial to the ESOP community. Since President Trump has advocated for pro-business government regulations, it is quite possible that his administration will take note of the current empirical data which shows that ESOP owned companies are more profitable, have lower turnover rate and can ride out recessions better than non-ESOP companies. Logically, this data supports legislation which would encourage the formation of more ESOP owned companies, such as the proposed legislation that would permit owners of S corporations to make a 1042 Election. Hopefully the Trump administration will work with Congress to have the proposed legislation enacted into law so that the tremendous tax advantages of ESOP transactions can be enjoyed by holders of S corporation stock in the near future. We will, of course, continue to monitor the status of the proposed legislation closely and alert our clients to any changes.