Section 1042: Sale of a Business to an ESOP

Transcription

1 Section 1042: Sale of a Business to an ESOP June 4, 2014 Jeremiah W. Doyle, IV Senior Vice President, Wealth Strategist

2 Table of Contents Overview Qualified Replacement Property Investment Strategy Questions 2

3 Section 1042: Overview Taxpayer May Defer Recognition of Capital Gain on Sale of Company Stock to an ESOP Owner sells stock to ESOP Reinvests cash proceeds in qualified replacement property (QRP) Gain on sale deferred until disposition of QRP 3

4 Section 1042: Requirements Important Highlights Taxpayer may defer recognition of capital gain on sale of qualified securities to an ESOP Taxpayer held qualified securities 3 years Taxpayer purchased qualified replacement securities 3 months before, or 12 months after, sale of qualified securities ESOP must own, after sale, 30% of each class, or 30% of total value, of all outstanding stock of company Taxpayer files election to defer gain on timely filed income tax return (plus extensions) for the year of sale of qualified securities Taxpayer must file Statement of Purchase of qualified replacement securities with tax return Employer must consent to application of certain excise taxes 4

5 Section 1042: How It Works Employer Establishes an ESOP Shareholder Contracts with ESOP to Sell Shares to ESOP ESOP (via Company) Borrows Funds from Financial Institution ESOP Uses Loan Proceeds to Buy Seller s Shares Employer Makes Contributions to ESOP to Pay Off Loan 5

6 Illustration Employer Loan Guarantee and Loan Repayment Loan $$$ Bank Plan Contribution ESOP Shares $ Shareholder 6

7 Section 1042: Who Can Participate Must Be Sale of Closely-held C Corporation Stock to ESOP S-corporations may not execute a Section 1042 rollover Selling Shareholder Must Be: Individual Trust Estate Partnership LLC (taxed as partnership) Selling Shareholder Cannot Be a C Corporation 7

8 Qualified Securities Definition Stock to Be Sold Employer securities issued by domestic C corporation Held by taxpayer at least three years Company has no outstanding stock readily tradable on established securities market within year before and after sale Must be closely-held stock Stock not received by taxpayer: In a distribution from a qualified plan, or Via exercise of NQSO, ISO or similar right granted to shareholder 8

9 30% Requirement Does Not Matter How ESOP Accumulated Shares Preferred Stock Not Included in Determining 30% Requirement Sale of Stock to ESOP by Two or More Shareholders Can Be Considered As Single Sale for 30% Requirement Must be prearranged as single, integrated transaction 30% threshold satisfied if ESOP Acquires stock via contribution by corporation, or Sale by shareholders 9

10 Qualified Replacement Property Stock to Be Purchased Seller must invest in qualified replacement property 15 months commencing three months prior to sale Sale 3 months 12 months Qualified Replacement Period 10

11 Qualified Replacement Property Definition Stock to Be Purchased Any security Issued by domestic operating corporation (publicly traded or closely held) More than 50% corporation s assets must be used in active conduct of trade or business May not have passive investment income in excess of 25% of corporation s gross receipts for tax year preceding year in which replacement securities purchased Is not the corporation which issued the qualified securities 11

12 Qualified Replacement Property Result Provides tax deferral on sale of business Converts investment in privately-held corporation to diversified portfolio of publicly-traded securities Gain subsequently recognized when there is a disposition of qualified replacement property 12

13 Qualified Replacement Property What Qualifies As Qualified Replacement Property? Stock, stock rights, bonds, debentures, warrants, notes and certificates of U.S. operating companies or other evidences of indebtedness in registered form and with coupons attached May be securities of either publicly-traded or closely-held corporations May be used to bankroll new operating company Bonds may not be good because they may be callable Some financial institutions have developed long-term, non-callable bonds (with put protection) with floating interest rates to meet the qualified replacement property definition (e.g., floating rate notes) 13

14 Qualified Replacement Property What Does Not Qualify As Replacement Property? Mutual funds Real estate Real Estate Investment Trusts (REITs) Municipal bonds U.S. Government securities Partnership interests Certificates of deposit Securities of foreign companies Securities of sponsoring corporation 14

15 Consequences of a Disposition Gain Recognized Only Taxed on Disposed Qualified Replacement Property Remaining Qualified Replacement Property Not Taxed 15

16 What Is a Disposition? Sale of Qualified Replacement Property Controlled by client Maturation of Qualified Replacement Property Determined by design of securities Calling of Qualified Replacement Property by Issuer Determined by outside market forces Seizure of Qualified Replacement Property by Judgment or Creditor 16

17 Investment Strategy Invest So That Client Can Control Timing of Disposition Buy and Hold Diversified Equities and High-quality, Non-callable Bonds of U.S. Operating Companies 17

18 Investment Strategy (cont.) Equities Exclude callable, preferred stocks, common stock rights and warrants, and economically sensitive stocks Buy common stock in well-established companies with high market share and a commitment to grow earnings and dividend income 18

19 Investment Strategy (cont.) Seek Securities with Call Protection More readily available with debt securities (e.g., floating rate notes (FRN)) Floating rate notes Issued by Fortune 500 companies (e.g., GE Capital, McDonalds, Proctor & Gamble, Merck, UPS) Maturity of 40 to 60 years with call protection for 25 to 30 years at relatively high premium 30/90 day floating rate based on LIBOR commercial paper plus spread (e.g., 25 basis points) Strategy Borrow against FRN (75% to 90% value) and invest loan proceeds in diversified portfolio, including assets that do not meet QRP definition Variable loan interest rate based on LIBOR plus spread Creates narrow spread between rate earned and interest paid Provides greater investment flexibility and potential greater return Margin call may result in disposition 19

20 Investment Strategy (cont.) Floating Rate Notes Invest proceeds in floating rate notes (FRN) Floating rate notes meet definition of qualified replacement property Borrow against FRN Loan repaid from either: Gain on investment of loan proceeds, or At death when FRN receives step-up in basis, eliminating any gain Reinvest loan proceeds in any investment May be invested in assets that do not meet definition as qualified replacement property 20

21 Borrowing against Floating Rate Notes Seller Reinvests Sales Proceeds FRN Pledged as collateral Purchases Mutual Funds Real Estate REITS Municipals U.S. Governments Partnership interests Certificates of deposit Foreign stock Bank 21

22 Borrowing against Floating Rate Notes Seller Reinvests Sales Proceeds FRN Purchases Mutual Funds Real Estate REITS Municipals U.S. Governments Partnership interests Certificates of deposit Foreign stock Qualified Replacement Property Pledged as collateral Bank 22

23 Floating Rate Notes Characteristics High credit quality (AAA/Aaa or AA/Aa rating) Principal stability interest adjusts monthly so principal value remains stable Interest rate adjusts to reflect changes in credit quality Limited risks Margin call value does not fluctuate due to variable interest rate allowing maximum margin loan borrowing Maturation 40- to 60-year maturity Call first call date is 25 to 30 years Liquidity investor may put notes to issuer in tenth year and every three years thereafter Tax-free access to capital investor may monetize by borrowing up to 75% to 90% value of FRN 23

24 Floating Rate Notes Advantages Generate liquidity Borrow up to 90% face value of FRN Minimize risk Little risk of decline in market value of note due to floating interest rate However, value may decline due to decrease in rating or issuing company Maximize tax deferral Buy FRN not likely to mature for long period of time Disadvantages Negative and variable cash flow Low interest rates or decline in credit rating may result in net interest payment as interest expense exceeds interest payment on FRN Liquidity and investment risk Loan is typically short-term and/or callable with full recourse to borrower 24

25 Other Considerations Cost Basis of Closely-held Stock Becomes Basis of Qualified Replacement Property Tax Can Be Avoided If Replacement Property Held until Death Stock receives step-up in basis Replacement Property May Be Donated to, and Sold By, Charitable Remainder Trust Income Tax Free 25

26 Compliance Requirements Statement of Election Statement of Purchase Employer Consent to Excise Taxes 26

27 Conclusion Section 1042 Opportunity for tax-free conversion of closely-held stock into diversified portfolio Technicalities Abound Private Letter Rulings Establish the Rules 27

28 QUESTIONS?

29 THANK YOU!

30 Seminar Survey Sale of a Business to an ESOP Your opinions and suggestions are extremely valuable to us. Please take a few minutes to respond to these questions so that we may improve future seminars. Thank you for your time and comments. 1. How useful was the seminar to you? Please circle one. not useful somewhat useful very useful Was the objective of the seminar met? no not sure yes 3. The presentation and presentation materials were: too detailed not detailed enough appropriate 4. The presentation was: too long too short the right length 5. The presentation skills of the presenters were: Poor fair excellent Would you recommend this seminar to an associate or friend? no not sure yes 7. The most convenient time for a seminar is: morning mid-day evening 8. The teleconference method of delivery was: Poor fair excellent What other seminar topics are of interest to you? 10. Any additional comments? 11. I am interested in receiving more information about family governance strategies. Name: Address: 12. The following person might also be interested in receiving information about family governance strategies. Name: Address: MANDATORY ATTENDANCE RECORD FOR CONTINUING EDUCATION CREDIT Please complete this section of the form if you are interested in obtaining CE Credit. Approval is pending for CFPs, CTFAs and attorneys in applicable states. Print Full Name Clearly Firm Name with Complete Address Address Type of Credit, please circle: CTFA, CFP, CPA, Legal CFPs MUST give the last 4 digits of Social Security # State & Bar Number Mandatory for Legal Credit Please return this form via fax to or to marissa.simmons@bnymellon.com. We hope that you enjoyed the seminar. 30

31 Disclosure This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. Pursuant to IRS Circular 230, we inform you that any tax information contained in this communication is not intended as tax advice and is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation. 31