What Is Section 1042 and How Does It Apply to Sellers?

Section 1042 of the Internal Revenue Code provides business owners with a way to defer capital gains taxes when selling their stock. This provision is particularly valuable for those transitioning ownership to an Employee Stock Ownership Plan (ESOP), aligning financial goals with succession planning.

Qualifying Gains Under the Code

Section 1042 permits sellers to defer capital gains taxes on the sale of C corporation stock to an ESOP. This benefit is not available for S corporations or other entities. The ESOP must acquire at least 30% of the company’s stock, ensuring meaningful employee ownership. Sellers are required to reinvest proceeds into Qualified Replacement Property (QRP) within 12 months. QRPs are securities from domestic operating corporations, excluding passive investment companies, to foster investment in active businesses that drive economic growth.

Requirements for Sellers

To qualify for Section 1042, sellers must meet specific criteria. Only C corporation stock is eligible. The ESOP must purchase at least 30% of the company’s stock to ensure significant employee participation. Additionally, sellers must have held the stock for at least three years, reflecting a long-term commitment to the company prior to transitioning ownership.

Qualified Replacement Property

Selecting appropriate QRP is critical for deferring capital gains taxes. QRPs must consist of securities issued by domestic operating corporations actively engaged in business. This ensures reinvested funds contribute to the broader economy. Sellers should evaluate the financial stability and industry position of potential QRPs. The 12-month reinvestment window requires careful planning to meet compliance requirements and maximize returns. Financial advisors experienced with Section 1042 can provide guidance in choosing suitable QRPs.

How to Make the Election

Making the Section 1042 election involves adhering to regulatory requirements and thorough preparation. Sellers must confirm the stock sale qualifies and reinvestment meets QRP criteria. Filing IRS Form 8023, “Elections Under Section 1042,” is required, detailing the transaction and ESOP purchaser. Precise documentation is essential to avoid potential audits or disqualification of the election.

Ongoing Reporting

After making the Section 1042 election, sellers must comply with ongoing reporting obligations to maintain the tax deferral. An annual statement must be filed with the seller’s tax return, including QRP details such as description, cost basis, and ownership changes. Retaining accurate records of QRP purchases is crucial in the event of an audit. Sellers should also be mindful of the tax consequences of early QRP dispositions, which can result in immediate recognition of the deferred gain. Consistent reporting ensures the continued benefits of the Section 1042 election.