10 Things to Know about IRC Section 1042

By Brian Khorsand

Section 1042 of the Internal Revenue Code allows for the deferral of capital gains tax when selling qualified securities to an employee stock ownership plan (ESOP). Here are 10 things we think selling shareholders should know about the 1042 election.

  1. In order to qualify for this tax deferral, you must sell C-corporation stock to an ESOP or a worker cooperative.  This is one of the criteria of a "qualified security."
  2. The ESOP must own at least 30 percent of the outstanding shares of the sponsor company at the close of the transaction.  Once this threshold is reached, any sale, regardless of the size would qualify for the deferral.
  3. Proceeds from the sale to the ESOP must be reinvested in qualified replacement property (QRP) within 12 months from the date of the transaction.  Reinvestment can start as early as three months prior to the transaction.
  4. Qualified Replacement Property (QRP) means securities of domestic operating corporations that earn no more than 25 percent of gross receipts from passive sources. 
  5. You must have held your stock for at least three years prior to date of the transaction. 
  6. Securities acquired through a stock option plan or certain other types of arrangements will not qualify for the deferral.
  7. If you choose to defer taxes by electing section 1042 and also continue employment with the sponsor company, then you would be prohibited from receiving share allocations of the shares you sold or any shares that have been subject to a 1042 election when contributions are made to the plan.  Same rules apply for certain members of your family.
  8. If you own greater than 25 percent of a sponsor company that has an ESOP and are employed with the firm, then you and certain family members would also be prohibited from receiving allocations of shares that were subject to a 1042 election, even if you never elected section 1042 yourself.
  9. If you are a selling shareholder and receive proceeds from an ESOP transaction in installments as a result of a seller financing arrangement, then you may not have the funds necessary to reinvest into QRP within the required time period.  There are tactics available that will accomplish the tax deferral in this type of situation.
  10. The IRS doesn't mess around.  Consult your tax advisors and work with financial advisors who have experience with 1042 transactions.  These types of transactions are complex and it is important to avoid pitfalls that may lead to complications and potential tax obligations down the line.

Given the increase in tax rates in recent years, the 1042 election has once again grown in popularity. It can be a great tool for a selling shareholder, but must be approached with diligence. This is a first in a series of articles devoted to section 1042. Stay tuned!