Under section 1042 of the Internal Revenue Code (the "Code"), a taxpayer may defer paying any federal income taxes on the sale of closely held stock to an ESOP, provided that he reinvests the proceeds in qualified replacement securities within twelve months of the date of sale.

In order to qualify for this deferral, the shareholder must sell closely held domestic company stock that he has held for three or more years. Also, stock that the shareholder originally acquired as section 83 stock, as restricted stock, as bargain stock, or as stock under a stock option plan or as a distribution from a qualified plan, does not qualify for this deferral. Secondly, after the transaction is complete, the ESOP must own at least 30% of the total value of all outstanding company stock (other than preferred stock). For purposes of this rule, any stock options are treated as though the optioned stock is already outstanding. Thirdly, the employer company must file a consent to the tax-free rollover transaction. Lastly, the funds must be reinvested in qualified replacement securities within the period beginning three months before the sale and ending 12 months after the sale.

"Qualified replacement securities" means any securities issued by a domestic corporation which did not, in the year preceding purchase by the taxpayer, have passive investment income (rents, royalties, dividends, interest, etc.) in excess of 25% of the gross receipts of such corporation. Accordingly, the proceeds may be reinvested in either corporate stocks or in corporate bonds of either publicly traded or privately held corporations. On the other hand, the proceeds may not be reinvested in government securities or in mutual funds.

The ESOP is required to hold the securities which it has purchased for at least three years after the acquisition date. If the ESOP disposes of part or all of these securities (other than by means of a normal distribution to a terminated or retired participant), then the company will be liable for a 10% penalty tax.

The seller must carry over his basis from the old securities to the new securities. Thus, if the seller subsequently sells the replacement securities, he will then incur an income tax based upon the difference between the fair market value of the securities at the time of sale and his original basis.

Some of the ways in which the new tax-free rollover provision may be especially useful to corporate owners are as follows:

1. Alternative to Sale. Purchase of an owner's stock by an ESOP will almost always be more beneficial to the owner than a sale or merger. For example, in the case of a sale to a third party, the seller will incur an income tax, will lose control, will usually lose his salary and fringe benefits, and will usually not be able to keep any retained equity. In comparison, there will be no federal income tax (and usually no state income tax) to the seller if he sells stock to an ESOP under the tax-free rollover provisions of section 1042 of the Code. In addition, the seller can keep control, can continue to receive his salary and fringe benefits, and can keep as much or as little of the stock as he desires. Of course, the seller will be subsequently taxed if he later sells the replacement securities. However, in most cases it will be advisable for the seller to defer the tax. By taking advantage of the tax-free rollover provision, for example, a shareholder can sell $1 million worth of his closely held stock to an ESOP and subsequently acquire $1 million worth of corporate stocks and/or bonds. By electing the tax-free rollover provision, he would save $200,000 or more in federal income taxes (assuming his basis in the stock is zero). This will enable him to receive dividends and interest on $1 million worth of securities rather than on only $800,000 worth of securities. Further, if the shareholder holds these securities until his death, he will escape the income tax altogether. One caveat should be mentioned with respect to the purchase of corporate bonds. A bond is deemed to be sold or exchanged when it matures. Thus, if a bond matures prior to the owner's death, the income tax will then be incurred. Accordingly, any shareholder who purchases corporate bonds as replacement securities should be careful to purchase long term bonds.

2. Investment Diversification. Previously, the only way in which an owner of a closely held company could achieve investment diversification without incurring an immediate income tax was to engage in a tax-free merger with a public company. In order to qualify for a tax-free merger, however, an owner must transfer 80% or more of his stock in exchange for public company stock. In effect, the owner has to give up control. Moreover, he still has no investment diversification.

Under the ESOP rollover provision, these problems are avoided. In order to get tax-free treatment, the ESOP need only acquire 30% ownership, and the replacement securities can be fully diversified.

The ESOP rollover provision also solves the problem of the locked-in shareholder. Under present law, if a shareholder holds his stock until death, the stock will receive a step-up in basis in his estate, and the income tax will be avoided. If, on the other hand, the shareholder sells part or all of his stock prior to his death, he will incur both an income tax and an estate tax. As a consequence, many shareholders have been locked into their existing investments. Now, with the tax-free rollover provision, these shareholders can sell part or all of their closely held stock and purchase marketable securities without incurring any federal income taxes.

3. Charitable Contributions. The ESOP can also facilitate charitable giving. Just as the ESOP functions as a market maker for those who hold stock in a non-publicly traded company, it can also function as a market for any public charity or tax-exempt organization to whom a stockholder might want to gift these securities. In this case once the stock has been contributed to the charity, the charity may, in turn, request that the ESOP repurchase those shares in order to create liquidity for the charity.

4. Private Foundations. The ESOP can also facilitate the company owner's desire to set up a private foundation. Regulations governing private foundations generally prohibit the owner of a closely-held business from contributing privately-held securities directly to a private foundation. However, under the tax-free rollover provision, this problem can be avoided. The owner may sell his closely-held securities to the ESOP and reinvest the proceeds tax-free into publicly-traded securities. He can then transfer the publicly-held securities to a charity or to a private foundation without violating the rules regarding the acquisition and holding of employer securities.

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