What Are the Rules for an ESOP 1042 Exchange?
Discover the mechanics of a Section 1042 exchange, from the initial transaction structure to the long-term management of replacement assets and their tax basis.
An Employee Stock Ownership Plan (ESOP) 1042 exchange, governed by Section 1042 of the Internal Revenue Code, is a tax-deferral strategy for owners of privately held companies. It allows a seller to postpone the capital gains tax from the sale of their company stock by selling the shares to an ESOP and reinvesting the proceeds into specific securities. This tax incentive is designed to encourage employee ownership.
The primary benefit is that the tax on the gain is not paid at the time of the sale but is deferred until the new investments are sold. This allows the full pre-tax proceeds to be invested, compounding over time without an immediate reduction for taxes. A 1042 exchange can also potentially eliminate the tax liability entirely through estate planning.
Qualification Requirements for a 1042 Exchange
For a transaction to be eligible for a 1042 exchange, the company whose stock is being sold must be a domestic C corporation at the time of the sale. A notable change is scheduled for sales occurring in 2028 and beyond, when stock in an S corporation will become eligible for a partial deferral of up to 10% of the gain. The transaction must involve the sale of qualified employer securities to the ESOP.
The seller must have held the stock for a minimum of three years prior to the sale. The stock sold must generally be common stock and cannot be shares that were acquired through certain employee compensation arrangements, such as stock options.
A condition of the exchange is the ownership level of the ESOP immediately following the sale. The ESOP must own at least 30% of the total value of the company’s outstanding stock after the transaction is complete. The selling shareholder and their immediate family are generally prohibited from receiving an allocation of the stock sold to the ESOP.
The Reinvestment Mandate and Qualified Replacement Property
A successful 1042 exchange requires the reinvestment of the sale proceeds into Qualified Replacement Property (QRP). QRPs are defined as securities, such as stocks and bonds, issued by domestic operating corporations.
An “operating corporation” is a U.S. company that uses more than 50% of its assets in the active conduct of a trade or business. The corporation also cannot have more than 25% of its gross receipts from passive income sources like rents, royalties, or dividends.
Examples of permissible QRPs include common stock in publicly traded companies, corporate bonds, and certain floating-rate notes. Conversely, several common investment types are not considered QRP, including:
- U.S. government securities
- Municipal bonds
- Mutual funds
- Exchange-traded funds (ETFs)
- Real estate
The seller has a 15-month window to purchase the QRP. This “replacement period” begins three months prior to the date of the sale to the ESOP and ends 12 months after the sale date. Failure to purchase sufficient QRP within this timeframe will result in the recognition of capital gains on any proceeds not properly reinvested.
Making the Election and Completing the Exchange
To use the tax deferral, the seller must make an election under Section 1042 by preparing a “Statement of Election.” This declaration must be attached to the seller’s federal income tax return for the year of the sale. The statement must include a description of the securities sold, the sale date, the seller’s cost basis, and the total amount realized.
The seller must also obtain a “Statement of Consent” from the employer whose employees are covered by the ESOP. This document confirms the company’s agreement to the application of Section 1042 and its associated responsibilities. This consent statement must also be filed with the seller’s tax return.
After purchasing the QRP, the seller must document the reinvestment with a “Statement of Purchase.” This document provides proof that the proceeds were used to acquire qualifying securities and must be notarized. It must contain a description of the QRP, its purchase date, and its cost.
The Statement of Election and the employer’s Statement of Consent are filed with the tax return for the year of the sale. The notarized Statement of Purchase is filed with the tax return for the year in which the QRP was acquired, which may be the same year or the following calendar year.
Tax Consequences and Basis of Qualified Replacement Property
The primary tax consequence of a 1042 exchange is that the deferred gain is embedded in the new Qualified Replacement Property (QRP) through a special basis calculation. The basis of the newly acquired QRP is not its purchase price. Instead, the QRP takes a “carryover basis,” which is its cost minus the amount of the deferred gain.
For example, if a seller sold stock with a $100,000 basis for $2 million and reinvested the entire amount into QRP, the deferred gain is $1.9 million. The basis in the new $2 million QRP portfolio is the original $100,000.
The deferred capital gain is triggered and becomes taxable upon the sale or disposition of the QRP. If the seller later sells a portion of their QRP, they will recognize a corresponding portion of the deferred gain. However, transfers of QRP by gift, upon the owner’s death, or in connection with a divorce do not trigger the gain.
A significant estate planning benefit arises if the seller holds the QRP until death. Upon death, the QRP receives a “step-up in basis” to its fair market value, which permanently eliminates the deferred capital gain. The seller’s heirs inherit the QRP with a basis equal to its current market value and can sell it without incurring capital gains tax on the built-in appreciation.