§1244 Stock and ESOPs

[BulldogTom]

I have a question for those of you who know something about §1244 Qualified Small Business Stock and ESOPS.

C Corporation was formed in 1987. Single shareholder with 100% of stock. Is looking at starting an ESOP for the employees. If he sells some of his shares to the ESOP, does he get a break on his Capital Gains tax? I seem to remember something about a 50% reduction in tax for the sale of §1244 stock, but I can't find it right now. It may have been something from way back when and no longer applies.

Any help pointing me in the right direction would be appreciated.

Thanks

Tom

Lodi, CA

[kcjenkins]

From Pub 550:

Sales of Stock to ESOPs or Certain Cooperatives

If you sold qualified securities held for at least 3 years to an employee stock ownership plan (ESOP) or eligible worker-owned cooperative, you may be able to elect to postpone all or part of the gain on the sale if you bought qualified replacement property (certain securities) within the period that began 3 months before the sale and ended 12 months after the sale. If you make the election, you must recognize gain on the sale only to the extent the proceeds from the sale exceed the cost of the qualified replacement property.

You must reduce the basis of the replacement property by any postponed gain. If you dispose of any replacement property, you may have to recognize all of the postponed gain.

Generally, to qualify for the election the ESOP or cooperative must own at least 30% of the outstanding stock of the corporation that issued the qualified securities. Also, the qualified replacement property must have been issued by a domestic operating corporation.

How to make the election. You must make the election no later than the due date (including extensions) for filing your tax return for the year in which you sold the stock. If your original return was filed on time, you may make the election on an amended return filed no later than 6 months after the due date of your return (excluding extensions). Enter “Filed pursuant to section 301.9100-2” at the top of the amended return, and file it at the same address you used for your original return.

How to report and postpone gain. Report the entire gain realized on line 8 of Schedule D. To make the choice to postpone gain, enter “Section 1042 election” in column (a) of the line directly below the line on which you reported the gain. Enter in column (f) the amount of the gain you are postponing or expecting to postpone. Enter it as a loss (in parentheses). If the actual postponed gain is different from the amount you report, file an amended return.

Also attach the following statements.

A “statement of election” that indicates you are making an election under section 1042(a) of the Internal Revenue Code and that includes the following information.

A description of the securities sold, the date of the sale, the amount realized on the sale, and the adjusted basis of the securities.

The name of the ESOP or cooperative to which the qualified securities were sold.

For a sale that was part of a single, interrelated transaction under a prearranged agreement between taxpayers involving other sales of qualified securities, the names and identifying numbers of the other taxpayers under the agreement and the number of shares sold by the other taxpayers.

A notarized “statement of purchase” describing the qualified replacement property, date of purchase, and the cost of the property and declaring the property to be qualified replacement property for the qualified stock you sold. The statement must have been notarized no later than 30 days after the purchase. If you have not yet purchased the qualified replacement property, you must attach the notarized “statement of purchase” to your income tax return for the year following the election year (or the election will not be valid).

A verified written statement of the domestic corporation whose employees are covered by the ESOP acquiring the securities, or of any authorized officer of the cooperative, consenting to the taxes under sections 4978 and 4979A of the Internal Revenue Code on certain dispositions, and prohibited allocations of the stock purchased by the ESOP or cooperative.

More information. For details, see section 1042 of the Internal Revenue Code and Regulations section 1.1042-1T.

[kcjenkins]

The American Recovery and Reinvestment Act of 2009 has increased the exclusion for gain on the sale of qualified small business stock (QSBS). The increased exclusion of 75% of the gain, within limits, makes this Section 1202 exclusion for QSBS acquired after February 17, 2009 and before 2011 an attractive option compared to the current capital gain tax rates, and an even more attractive option compared to the increased capital gain rates that are scheduled to apply starting in 2011. Imposition of the built-in gains tax has been suspended for 2009 and 2010 for certain corporations.

Sales of stock to ESOPs.

Small business owners have another option to avoiding immediate tax on the sale of their stock. If you (or your executor) sell your stock to an ESOP (Employee Stock Ownership Plan) and purchase qualified replacement property within 3 months prior to, or 12 months after, the sale of your stock to the ESOP you can roll over the gain on your original shares. Thus, any gain will not be taxable until you sell the replacement property.

Qualified replacement property is defined as securities of a corporation that does not have passive investment income in excess of 25% of its gross receipts and where more than 50% of the assets are used in the active conduct of a trade or business. Other than these two requirements, you're not limited to any type of corporation. It could be stock in another small business, or shares of a New York Stock Exchange traded company.

There are several other important requirements. One, after the sale to the ESOP, it must hold at least 30% of the total value of the employer securities outstanding at that time. That may be a difficult test to meet if there are a number of owners, and only one wants to cash out. Two, the benefits only apply to C, not S, corporations. Three, you must have owned the stock for at least 3 years before the date of sale.

The eventual sale of the replacement property will trigger any gain that's unrecognized because of these roll over rules.

[kcjenkins]

http://www.aicpa.org/Magazines+and+Newslet...identifying.htm

Good reading.

[BulldogTom]

Thanks KC. I think it is the §1202 exclusion that I am looking for.

Tom

Lodi, CA