ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with an advisor in Illinois involved questions on stock exchanges under IRC Sec. 1042. The advisor asked: “My client has an ESOP and several employees have inquired about making a ‘1042 election.’ Can you explain what a 1042 election is and how it is made?”
Highlights of the Discussion
How to make a proper 1042 election is a very important tax and legal question. That is why my first response is to say that an individual contemplating such a move should work with an experienced tax or legal advisor to ensure proper filing of the 1042 election. What follows is for informational purposes only and should not be construed or relied upon as tax or legal advice.
Basically, a 1042 election allows qualifying individuals and entities to defer capital gains tax on “qualified securities” sold to an Employee Stock Ownership Plan (ESOP) if the proceeds of the sale are reinvested in “qualified replacement property” (QRP) as defined in IRC Sec. 1042(c)(4). For a general overview of qualified securities and QRP, please see an earlier Case of the Week ESOP Tax Advantaged 1042 Exchange.
Treasury Regulations Section 1.1042-1T prescribe the requirements of a proper 1042 Election. Also, see IRS Publication 550, Investment Income and Expenses page 62 for filing details as well as Part II of IRS Form 8949, Sales and Other Dispositions of Capital Assets and the instructions, along with Schedule D of Form 1040 and the accompanying instructions.
The IRS guidance states a taxpayer that meets the qualifications for a 1042 election, must attach three statements to his or her tax return filed with the IRS to successfully communicate his or her intent to make a 1042 election to defer capital gains tax (See Pub. 550 page 63 and PLR 200019002).
- Statement of Election: The filer must demonstrate his or her express written intent to elect not to recognize capital gains with respect to the sale of C corporation stock to an ESOP under IRC Sec. 1042. A very detailed description of the sale must accompany the election.
- Notarized Statement of Purchase: The filer must provide a signed and timely notarized statement that he or she has completed the sale of stock to the ESOP. The statement must also describe the QRP, date of purchase, the cost of the property and declare the property to be QRP for the qualified stock sold to the ESOP.
- Statement of Consent: The company sponsoring the ESOP must provide written consent to allow the filer to defer taxes on the sale. It must also consent to the application of certain IRS penalties under IRC Secs. 4978 and 4979A if the company sells shares purchased by the ESOP within three years or allocates them to the selling shareholder(s) and/or their families.
According to Publication 550, the filer must also attach to his or her tax filing an appropriately completed IRS Form 8949.
Conclusion
As this general description alludes, making a 1042 election to defer capital gains tax on a sale of qualified securities to an ESOP is highly nuanced. Anyone contemplating such a transaction should work with an experienced tax or legal advisor to ensure proper compliance.
