Employee Stock Ownership Plan, IRC Section 1042

What Is Employee Stock Ownership Plan, IRC Section 1042?

IRC Section 1042 and qualified replacement property

• A 1042 ESOP Exchange allows a shareholder to exchange his or her interest in a private company for a portfolio of qualified replacement property without paying any capital gains taxes on the transaction.
• Capital gains tax is deferred as long as the qualified replacement property is held. Through the use of IRC Section 1042, the Qualified Replacement Property (QRP) is assigned the basis of the original investment.

Investments that qualify for QRP:

• Common stock
• Preferred stock
• Convertible bonds
• Corporate fixed rate notes
• Corporate floating rate notes (FRNs)

If a U.S. corporation uses 50 percent or more of its assets in an active trade or business and does not receive greater than 25 percent of its gross receipts from passive income, the securities can be used as QRP. These strategies let the business owner sell their business and defer the tax until the securities mature, are called by the issuer, or sold. Thus, a business owner might be able to defer or eliminate capital gains on the sale of their business.

Wealth management and ESOPs

Business owners can generate income from their qualified replacement property by investing in high-dividend stocks or long-term fixed income securities. This approach allows them to generate income without triggering tax consequences.

Business owners can invest in floatingrate notes, because they are designed specifically for ESOP sales. These securities are issued by major corporations, which have maturities of 30 to 40 years or more and offer a variable interest rate based on a short-term market index. The rate is typically monthly or quarterly, depending on the security.

Highly rated floating-rate notes are marginable for up to 90 percent or more of their market value. As a result, business owners can monetize them by borrowing a substantial portion of their market value and then reinvesting borrowed funds in a diversified portfolio of stocks, bonds and other assets.

The investment portfolio can then be actively managed without triggering tax on the deferred capital gains resulting from the ESOP sale. Business owners will have to pay interest on their margin loan, but the rate will be relatively low and the interest paid may be partially or fully offset by the interest earned on floating-rate ESOP notes.

Reinvesting the proceeds from an ESOP is complex and requires the assistance of a professional who is well versed in ESOPs and qualified replacement properties. Business owners do not want to find themselves liable for taxes they thought they had deferred or unable to withdraw assets for the fear of triggering tax consequences.

Why RBC Corporate and Executive Services?

Our experienced professionals can work with your RBC Wealth Management financial advisor to help facilitate an Employee Stock Ownership Plan for your privately held S or C Corporation. The Corporate and Executive team and The ESOP Plan Advisors can help advise you in a strategy to exit your business.