The ESOP 1042 “Tax-Free” Rollover
Savings May Exceed 35%
ESOP Services, Inc.
Section 1042 of the Internal Revenue Code allows business owners to sell their company stock to an ESOP and defer federal (and often state) tax on the transaction. The IRC 1042 election is now more valuable than ever.
Capital Gains Rate
State Tax Rate
(rates vary from
0% – 13%)
|NonESOP sale- Taxes||$2,350,000||$650,000||$3,000,000|
|ESOP-IRC 1042 sale-Taxes||$0.00||$0.00||$0.00|
Higher New Capital Gains Rates:
For 2013, the federal capital gains rate is 20% on income over defined thresholds. The new 3.8% Medicare surtax on net investment income for taxpayers with AGI over defined thresholds additionally applies to create a combined effective federal capital gains tax rate of 23.5% for many high end tax payers.
This analysis makes a simplifying assumption that the state capital gains or income tax is not deductible for federal income tax purposes because of the phase out for high-income individuals. Even if state taxes are deductible, the benefit of this deduction may be offset in part or in full by alternative minimum taxes for many high-income individuals. It also assumes that the state tax can be deferred, along with the federal capital gains tax, and that the seller exceeds the income thresholds
1. The Seller must:
a. Qualify for long-term capital gains treatment for the transaction
b. Have at least a 3-year holding period in the stock
c. Be an individual, partnership, LLC, trust, or S corporation, but not a C corporation
d. Reinvest the proceeds in Qualified Replacement Property (QRP) within 12 months after the ESOP stock purchase (or during the 3 month period preceding the ESOP stock purchase)
2. The Company sponsoring the ESOP must:
a. Be a C corporation at the time the ESOP acquires stock (S corporations can convert)
b. Not have publicly traded securities
3. The ESOP must:
a. Own at least 30% of the company’s stock immediately following the ESOP’s purchase
b. Hold the stock for at least 3 years following the purchase, otherwise the company incurs an excise tax of 10% on the proceeds from the disposition of the ESOP stock (exceptions for some tax free reorganizations)
a. Includes stocks or bonds of domestic operating corporations
b. Does not include foreign or passive investments, such as mutual funds, certificates of deposits, securities issued by foreign corporations, securities issued by a government or agency, such as treasury bonds or municipal bonds
5. Additional Rules
a. Section 83 stock (stock acquired by an individual in connection with the performance of services or under employee stock option programs) does not qualify
b. The seller, certain family members, and 25+% shareholders may be excluded from the ESOP
6. QRP held until death receives a “stepped up” basis under current tax laws
a. Deferred tax liability is extinguished at death
b. QRP can be leveraged during the owners’ lifetime.
For qualified shareholders selling to an ESOP, the tax savings can range from 23.5% to 37%.
This update should not be considered legal advice or tax advice. Shareholders should consult with experienced legal and tax advisors.