To defer capital gains taxes under a Section 1042 election, a selling shareholder must reinvest the proceeds from the sale of their business to an ESOP into Qualified Replacement Property (QRP). This reinvestment must occur within a specific window: either within the 3 months prior to the ESOP sale or within 12 months after the transaction closes.
What Qualifies as Qualified Replacement Property?
The IRS defines QRP as a security issued by a U.S. operating corporation that meets all of the following criteria:
- Did not have passive income greater than 25% of gross receipts in the previous taxable year;
- Is not the corporation that issued the qualified securities, which such security is replacing, or a member of the same controlled group of corporations; and
- More than 50% of the assets of the corporation were utilized in an active trade or business
In practical terms, QRP typically consists of stocks or bonds from domestic corporations actively involved in an active trade or business.
How the Tax Deferral Works
If the selling shareholder reinvests 100% of the ESOP sale proceeds into QRP, the capital gains tax is deferred as long as the QRP is held. If the QRP is held until death, the shareholder’s heirs or estate receive a step-up in basis, thereby defeating the capital gains tax permanently. However, if the QRP is sold during the shareholder’s lifetime, the capital gains tax will be triggered.
In other words, to fully realize the benefits of a 1042 election, a seller should choose QRP that they are confident in holding for the rest of their life.
Common Pitfalls to Avoid
While purchasing stocks from major indexes like the Nasdaq 100 may seem like a simple way to fulfill the QRP requirement, there are two key issues to consider:
- Upfront Cash: Most ESOP sales are not all-cash transactions. Typically, sellers receive 25–35% of the purchase price in cash at closing, with the remainder structured as a seller note. This makes it difficult—if not impossible—to reinvest the full sale price within the required 12-month period.
- Long-Term Commitment: The likelihood of a selling shareholder wanting to hold a portfolio of public stocks indefinitely without the need to rebalance or sell a particular stock is low. For instance, companies that once seemed rock-solid, like Blockbuster or Eastman Kodak, can decline or disappear due to market shifts. Selling those positions prematurely would trigger capital gains tax, undermining the purpose of the 1042 deferral.
Floating Rate Notes (FRN): Imperfect QRP Financing Solution
To finance the purchase of QRP under Section 1042, banks will typically lend up to 90% of the face value of a Floating Rate Note (FRN). Using leverage enables the purchase of FRN equal to 100% of the taxable gain.
The FRN loan requires the seller to pay annual interest on the borrowed 90%, and the loan remains in place for the rest of the seller’s life. To secure the loan, banks will require a personal guarantee from the seller.
Strategic Planning is Essential
Because QRP selection and timing are so critical, selling shareholders should work closely with advisors who understand the technical, tax, and investment aspects of the 1042 election. A thoughtful strategy helps ensure compliance, tax deferral, and financial security.
Learn more about the power of Section 1042 and why it was created to support both economic impact and retirement security.
Explore Lazear’s proprietary 1042 tax solution by clicking here.
