Understanding 1042 Rollovers: How to Defer Capital Gains Taxes with an ESOP

For business owners looking to sell their company, the prospect of a significant tax bill can take the shine off an otherwise lucrative exit. Following a typical M&A transaction, capital gains taxes can take a hefty 20-38% of the sale proceeds. However, there’s an exception when the buyer is an Employee Stock Ownership Plan (ESOP).

Under Section 1042 of the U.S. Internal Revenue Code, sellers can defer or potentially eliminate capital gains taxes on the sale of stock to ESOPs by reinvesting the sale proceeds in Qualified Replacement Property (QRP). This strategy, commonly called a 1042 rollover or 1042 exchange, offers a substantial tax advantage similar to the well-known 1031 exchange for real estate.

What Is a 1042 Rollover?

A 1042 rollover allows selling shareholders to defer capital gains taxes when they sell stock to an ESOP and reinvest the proceeds in qualifying securities. To take advantage of this tax deferral, the seller must reinvest in Qualified Replacement Property (QRP), which are securities issued by U.S. operating companies. These include:

• Common stock

• Convertible bonds

• Corporate fixed-rate bonds

• Corporate floating-rate notes

U.S. Treasury Bonds and mutual funds, however, do not qualify as QRPs.

Who Qualifies for a 1042 Exchange?

Not every sale to an ESOP is eligible for a 1042 rollover. To qualify, the seller must meet specific criteria:

• Ownership Requirement: The selling shareholder must have owned the shares for at least three years before the ESOP sale.

• ESOP Ownership: After the transaction, the ESOP trust must own at least 30% of the company’s stock.

• Timing of Reinvestment: Sellers have 12 months after the sale to reinvest their proceeds in a QRP.

• Exclusion of Family Participation: Neither the seller nor their immediate family can participate in the Employee Stock Ownership Plan post-sale.

ESOP Structure Matters: C Corporation vs. S Corporation

To fully capitalize on a 1042 rollover, the company must be structured as a C corporation at the time of the ESOP transaction. Sellers of C corporations can reinvest 100% of their sale proceeds in a QRP, deferring capital gains taxes indefinitely.

For S corporations, however, the benefit is more limited. Only 10% of the proceeds from the sale to the ESOP can be deferred using a QRP, while the remainder is subject to standard capital gains taxes. Some S corporations elect to convert to C corporations before selling to an ESOP to maximize their tax benefits.

The Role of Qualified Replacement Property (QRP)

While the 1042 rollover offers a significant tax deferral opportunity, QRPs come with their own set of rules:

• Holding Requirements: If the seller disposes of the QRP during their lifetime, it will trigger the deferred capital gains taxes from the original ESOP sale. However, if the QRP is held until death, it receives a step-up in basis, meaning it can be sold tax-free by the seller's heirs.

• Estate Planning Benefits: Because of the step-up in basis, 1042 exchanges can be particularly advantageous for estate planning. Selling shareholders can pass on these assets to their heirs without the original capital gains tax burden.

• Non-Taxable Dispositions: Gifts of QRPs or transfers related to divorce are not considered taxable events, further enhancing their appeal for long-term planning.

Monetizing QRPs

One of the more attractive aspects of 1042 exchanges is that QRPs can often be purchased on margin. This means the seller can finance a portion of the QRP transaction with a loan, effectively accessing a significant portion of their liquidity without triggering capital gains taxes.

For example, a selling shareholder can use part of their sale proceeds to buy QRPs on margin and reinvest the remaining liquidity into other ventures, real estate, or personal financial strategies—all while deferring the capital gains tax from the original ESOP sale.

The Legislative Outlook: Is 1042 Here to Stay?

Since its introduction in 1986, the 1042 rollover has received strong bipartisan support in Congress, and subsequent legislation has expanded its benefits. Most recently, in December 2022, Congress passed an amendment further solidifying the tax incentive. Given this track record, the 1042 exchange is likely to remain a valuable tool for business owners.

However, it’s worth noting that some potential changes could affect aspects of this strategy. For example, the Biden Administration considered proposals to eliminate the step-up in basis benefit for capital gains. While these changes may not be imminent, they serve as a reminder that future modifications to the tax code are always possible.

The Bottom Line: Why 1042 Rollovers Offer a Competitive Edge

In an M&A world where taxes can dramatically reduce the net proceeds of a sale, the 1042 rollover stands out as a unique and powerful tool for business owners selling to an ESOP. By allowing sellers to defer or eliminate capital gains taxes and providing opportunities for estate planning, the 1042 exchange can be an excellent strategy for maximizing the financial benefits of a liquidity event.

As the saying goes, "It’s not what you make, it’s what you keep." For business owners considering an ESOP sale, the 1042 rollover offers an opportunity to keep more of their hard-earned wealth while benefiting employees and creating a lasting legacy.

To fully capitalize on the 1042 rollover, business owners should consult with tax, legal, and financial advisors experienced in ESOP transactions to ensure the transaction is structured to take full advantage of these benefits.