Tax Treatment of ESOPs: Your Guide to Internal Revenue Code Section 1042

Shareholders and owners of closely held businesses who are looking for the right exit strategy to diversify their portfolio and plan for the next phase of life have numerous alternatives to consider. Among these, perhaps the most tax-favorable option is selling their shares to an Employee Stock Ownership Plan (ESOP).
 
An exit strategy should not be selected based solely on tax consequences, but if the decision is made to sell the business to an ESOP, the transaction can be structured strategically to bring significant tax benefits to selling shareholders. For shareholders who meet certain conditions and requirements, Section 1042 of the Internal Revenue Code provides an opportunity to defer capital gains taxes on the sale.
 
This tax-free rollover, also known as the 1042 transaction, is one of the most effective tax provisions passed to encourage the growth of ESOPs. Read on to learn more about Section 1042 and understand whether it’s right for you.

By Dan Markowitz, CPA