Employee Stock Ownership Plan (“ESOP”) transactions take a variety of forms, and decisions regarding structure, tax status and financing are unique to each selling shareholder. One key decision point surrounds a seller making a section 1042 election on the sale of stock, which allows for the deferral of up to 100% of capital gains tax realized on the sale of the business to an ESOP. While a powerful tool, the 1042 election can add some complexity to a transaction, and discussing the impacts to the shareholders and the Company is paramount. Throughout this article, we will discuss the basics of the 1042 election, who is eligible and various transaction considerations that are necessary when deciding whether or not to make the election.
Basics of 1042
As stated, the 1042 election allows a selling shareholder to defer up to 100% of capital gains taxes realized on the sale of a business to an ESOP, potentially indefinitely. In order to defer that gain, a selling shareholder must purchase a portfolio of qualified replacement property (“QRP”) within 12 months of the transaction closing date in an amount equal to the capital gain to be protected. Investments in QRP can be made in public and private U.S. Stocks and Bonds that meet certain criteria – investments such as ETFs, mutual funds and REITs do not qualify as QRP. For example, if a seller realizes a $50 million capital gain on sale, then that seller would need to invest $50 million into a QRP portfolio to defer the gain. If that seller would like to defer only 50% of the gain, then they would invest $25 million into a QRP portfolio. With careful planning, the tax deferral will be perfected so long as that QRP portfolio is outstanding, and, upon the shareholders’ passing, the portfolio would receive a step-up in basis, eliminating the capital gain tax for estate beneficiaries. Due to this tax deferral, sellers electing 1042 may find the ESOP provides a premium to post-transaction proceeds compared to a taxable third-party sale at similar or potentially lower valuations. On the $50 million gain, assuming a 25% capital gain tax, that equates to a post-tax proceeds premium of $12.5 million compared to a taxable third-party sale at the same valuation. For a seller to receive the same post-tax consideration in a third-party sale, the transaction would need to be approximately $66 million (or a 33% sale price premium).
Eligibility Requirements for 1042 Election
If a seller wants to elect 1042 treatment upon sale, certain eligibility requirements must be met at both the corporate and shareholder levels. First, the Company must be taxed as a C-corporation at the time of sale. For companies that are not currently a C-corporation, reorganization and corporate restructuring will be necessary to meet this requirement, which can add time to a transaction. Second, the shareholder must own the shares for a minimum of three years prior to the transaction. Additionally, those shares cannot have been gifted or granted to the shareholders. Third, the ESOP must purchase a minimum of 30% of the stock and the stock must be purchased directly by the ESOP Trust. Finally, the selling shareholders and direct family members cannot participate in the ESOP.
Clearly, electing 1042 involves numerous decision points compared to other transaction structures. Discussing the impacts on the shareholders, Company and ESOP participants is imperative. Sellers should put together a trusted team of advisors, including a sell-side advisor, tax advisor, financial advisor and estate planner, to review the implications of the sale and plan properly for the future.
1042 Investment Strategies
Once a seller decides to elect 1042, specific attention can be paid towards the investment strategy of the QRP. While a number of investment strategies exist, the three most popular are the Passive Strategy, Active Strategy and Blended Strategy.
- Passive Strategy — Acquire a passive portfolio of qualified replacement property securities intended to maintain stability throughout the shareholder’s lifetime. The Seller has the option to acknowledge capital gain by selling one or more of the securities.
- Active Strategy — Purchase “leveraged” qualified replacement property using corporate-issued floating rate notes (“FRNs”) and a “monetization” loan. This option typically provides the Selling Shareholder with greater liquidity and flexibility and may result in a higher overall investment return.
- Blended Strategy — Combines both the passive and active strategies to better meet the Selling Shareholder’s investment goals and objectives.
1042 Investment Strategies – The Active Strategy
The Active Strategy uses leverage and special ESOP Bonds—floating rate notes with long terms—to build the QRP portfolio while reducing the amount of equity the sellers need to invest. To use this strategy, sellers make a down payment of 10–12% of the portfolio’s value and borrow the rest using the QRP assets as collateral. For example, if a seller chooses 1042 treatment on a $100 million gain, they would invest $12 million and borrow $88 million against the portfolio. The interest income from the floating rate notes helps offset most of the loan’s interest, though there is still a small cost to maintain the portfolio. However, this cost is usually much lower than what the seller would owe in capital gains tax. The strategy gives the seller flexibility to invest the remaining $88 million as they choose.
Impacts on the Company
The 1042 election is primarily a personal seller decision, though that decision will have short- and mid-term impacts on the Company. The primary impact on the Company is that, as a C-corp, taxes are paid at the company level rather than the shareholder level, which reduces the tax benefit of the ESOP Trust. If the Company has to go through a reorganization to allow for the 1042 election, the Company will be taxed as a C-corp for up to five years post-transaction, using cash and potentially delaying the repayment of the transaction debt. Depending on the Company’s current tax status and organization, there may be an opportunity to reduce the post-transaction C-corp period, though those cases require additional diligence.
While the company does have to pay corporate taxes as a C-corp, the tax advantages of the ESOP are not completely lost. First, the interest expense on the transaction debt is tax-deductible, lowering the tax burden on the Company. Second, since the ESOP Trust must purchase shares directly, the contribution to the internal loan should be higher than a similar redemption transaction. Given the contribution is a tax-deductible expense (up to certain limits) that internal loan payment reduces the corporate tax burden.
Summary
The 1042 election is a powerful tool that sellers can utilize in the sale to an ESOP. Given the complexities and impacts to the transaction, it is imperative that sellers speak with their advisors early in the process. If you have any questions regarding the 1042 election or other transaction structures, Prairie is more than willing to have a conversation and help you think through the various impacts to the sellers, the Company and the ESOP participants.
Joseph Labetti is a Vice President at Prairie Capital Advisors, Inc. He can be contacted at 630.413.5586 or by email at jlabetti@prairiecap.com.
Download the full article above.
