3823 / What is a Section 1042 election? What rules apply to qualified sales to an ESOP?

A taxpayer or executor who sells qualified securities to an Employee Stock Ownership Plan (“ESOP”) ( Q 3817) and purchases qualified replacement property may be able to elect to defer recognition of long-term capital gain on the sale.¹ This is referred to as a Section 1042 election. If the election is made, the taxpayer or estate recognizes gain on the sale only to the extent that the amount realized on the sale exceeds the cost of the securities purchased to replace the stock sold to the ESOP.²

The election must be made in a written “statement of election” and filed with the taxpayer’s return for the year of sale by the due date for that year, including extensions.³ The statement of election must contain specific information set forth in the regulations.⁴ The election cannot be made on an amended return, and, once made, is irrevocable.⁵ In the absence of such an election, the Tax Court denied the deferral of gain to a taxpayer whose estate argued that he had “substantially complied” with the election requirements.⁶ Similarly, where a taxpayer failed, through his accountant’s error, to make a timely election, the IRS strictly construed the statutory deadline.⁷

A taxpayer must file a statement from the employer whose employees are covered by the ESOP consenting to the application of an excise tax⁸ if the transferred securities are disposed of prematurely (see below) and a tax⁹ on prohibited allocations of securities acquired in the sale.¹⁰ Failure to substantially comply with the statement of election and statement of consent requirements has resulted in denial of nonrecognition treatment.¹¹

The qualified replacement property must be purchased during the period that begins three months before the sale of qualified securities and ends 12 months after the sale.¹² If the replacement property has not yet been purchased when the statement of election is required, the taxpayer must file a notarized statement of purchase with his or her income tax return for the tax year following the year for which the election was made. The statement of purchase must contain specific information and must be notarized within 30 days of the purchase.¹³ The IRS has found that taxpayers had substantially complied with the election requirement where they had relied on tax professionals concerning the election requirements and immediately acted to correct the noncompliance.¹⁴

Qualified securities, for purposes of a Section 1042 exchange, means stock (1) in a domestic C corporation (i.e., not an S corporation) that has no stock outstanding that is readily tradable on an established securities market, and (2) that was not (x) acquired from a qualified pension, profit sharing, or stock bonus plan, (y) acquired under an employer stock option plan or an employee stock purchase plan, or (z) transferred to the individual in connection with his or her performance of services to the corporation.¹⁵ In addition, the taxpayer must have held the qualified securities for at least three years before the sale to the ESOP.¹⁶ Nonrecognition does not apply to any gain on the sale of any qualified securities that is includable in the gross income of any C corporation.¹⁷

Qualified replacement property means securities issued by a domestic operating corporation that (1) did not have more than 25 percent of its gross receipts in certain passive investment income (including, generally, receipts from rents, royalties, dividends, interest, annuities, and sales and exchanges of stock or securities) for the taxable year preceding the tax year in which the security was purchased, and (2) is not the corporation or a member of its controlled group ( Q 3933) that issued the qualified securities being replaced.¹⁸

If a taxpayer does not intend to reinvest the total amount required, under IRC Section 1042, to completely defer the gain on the sale in replacement securities, the installment method may be available for the gain that does not qualify for nonrecognition, provided that the sale otherwise qualifies as an installment sale. The amount of gain is the same proportion of the installment payment actually received in such year that the total gain to be recognized under IRC Section 1042 bears to the total amount realized. The gain is recognized in the taxable year in which the installment payment is made.¹⁹

A taxpayer’s basis in his or her replacement securities is reduced by the amount of gain not recognized. If more than one item is purchased, the unrecognized gain is apportioned among them.²⁰ If a taxpayer dies while still holding replacement securities, the basis provisions of IRC Section 1014 prevail and the replacement securities receive a stepped-up basis.²¹ The holding period of the replacement property includes the holding period of the securities sold.²²

To qualify for nonrecognition, the sale must meet certain additional requirements. The ESOP generally must own, immediately after the sale, at least 30 percent of each class of outstanding stock of the corporation that issued the qualified securities, or the total value of outstanding employer securities.²³

The IRS has determined that where a note acquired by a company’s owners from an ESOP in exchange for stock was a cash equivalent for tax purposes, the stock in a separate corporation acquired in exchange for the note constituted qualified replacement property.²⁴

If a taxpayer disposes of any qualified replacement property, he or she generally will recognize gain (if any) to the extent that it was not recognized when the replacement property was acquired.²⁵ If a taxpayer owns stock representing control of a corporation that issued the replacement property, he or she will be treated as having disposed of his or her qualified replacement property if that corporation disposes of a substantial portion of its assets other than in the ordinary course of its trade or business.

The recapture rules do not apply if the transfer of the qualified replacement property is:

(1)  in a reorganization (if certain requirements are met);

(2)  by reason of the death of the person making the original election;

(3)  by gift (even if a charitable deduction is obtained);²⁶ or

(4)  in a subsequent transfer that is eligible for an election not to recognize gain under the rules discussed above.²⁷

A transfer to a revocable trust by a taxpayer will not trigger recapture where the grantor (i.e., the taxpayer) will continue to be treated as the owner of the property transferred to the grantor trust.²⁸

The IRS also has determined that the distribution of qualified replacement property by a trust to its beneficiary was not a disposition for purposes of IRC Section 1042(e); thus, the recapture rules did not apply.²⁹

Although the transfer of qualified replacement property to a charitable remainder unitrust technically was a “disposition,” it did not result in recapture of the deferred gain, because the donors did not realize gain on the transaction.³⁰

Subsequent Dispositions by the ESOP

If, within three years, an ESOP disposes of stock acquired in a sale in which the seller was permitted to defer the recognition of income (as discussed above) and, as a result, the number of the ESOP’s shares falls below the number of employer securities held immediately after the sale, or the value is less than 30 percent of the total value of all employer securities, the disposition will be subject to a tax equal to 10 percent of the amount realized on the disposition, unless the disposition is a distribution made by reason of (1) the death or disability of an employee, (2) retirement of the employee after age 59½, or (3) separation of the employee from service for any period that results in a one year break in service.³¹