One benefit available to C corporations forming employee stock ownership plans (ESOPs) is that shareholder gain can be deferred when the owners sell their stock to the ESOP.
The usual result is the owners end up with low-basis stock in public companies. ((See “ESOP (Employee Stock Ownership Plan) Facts,” National Center for Employee Ownership, esop.org.))
S corporation shareholders selling their stock to the ESOP don’t qualify for the same tax deferral opportunity available to C corporation shareholders. ((Tax code Section 1042(c)(1)(A), IRS Audit Manual on ESOPs.))
But one of the advantages of ESOPs for C corporations is that the owner’s gain on the sale of stock to the ESOP may go unrecognized. The cost of the gain on the stock sale to the ESOP being tax-free is that the basis in the replacement asset is low. The gain that goes unrecognized is a minus to the cost of the stock reinvestment.
California has a comparable rule. The gain may also be much reduced for state tax purposes. ((California Revenue and Taxation Code Section 18042.)) Any reduction in state taxes is even more important after the 2017 Tax Cuts and Jobs Act which generally limits the individual’s itemized deduction for state income taxes to a maximum of $10,000.
The relief at the shareholder level doesn’t eliminate the entity level tax of a C corporation. Whereas an ESOP owning an S corporation can be tantamount to a tax-free operating structure because the business income flowing through to the ESOP is exempt from tax, the C corporation continues to be subject to tax even if it is partially or wholly owned by an ESOP.
Yet a major advantage to the C corporation structure is the gain deferral benefit.
The shareholder must have held the stock at least three years. While the seller(s) is typically an individual, qualification here isn’t necessarily limited to direct sales by an individual. Looking to the three months prior to the sale and 12-month period following the sale to the ESOP, the selling shareholder must reinvest in qualifying replacement securities. The proceeds are typically invested in publicly traded stock but the proceeds may also be reinvested in a closely-held corporation. The reinvestment must generally be in an operating company. Too much passive income within the reinvestment is a potential problem. In so far as reinvestment, debt instruments, and preferred stock can qualify.
After the sale, the ESOP must own at least 30% of the company that establishes the ESOP. As to this stock sold to the ESOP, the basic concept is one of shareholders transitioning into the ESOP structure. The stock being sold here can’t have come from the ESOP. The stock can’t have come from a stock option.
There are myriad technical requirements to qualify for deferral of gain, including tax filing requirements.
Our focus is maintaining the gain deferral.
As to low-basis public stock that was purchased in an ESOP gain deferral context, the general rule is dispositions trigger gain. One of the few exceptions is that gifts of such stock don’t trigger gain. This suggests giving such securities to charity, in lieu of cash, if one has a pattern of charitable giving. The general rule is that gifts of such appreciated publicly traded stock yield donation deductions at fair market value.
Low-basis, high-value publicly traded stock is often an ideal candidate for future charitable contributions, or partially charitable transfers, such as funding a charitable remainder trust (CRT) under Section 664. ((See Private Letter Rulings 9547023, 9515002, 9533038, 9732023, 9438012.)) There have been some concerns as to whether transfers to a charitable remainder trust qualified, because the donor also retains or directs a retained income stream, such that a transfer to such trust isn’t entirely a gift. The Internal Revenue Service has ruled privately on the issue, but technically the public cannot rely on such rulings in the same manner as a public ruling.
In general, in an ESOP context, it appears that when qualified replacement property (usually low basis public stock) is transferred to a public charity, private foundation, or charitable remainder trust, there would be no tax gain realized due to Section 1042(e)(3). This provision says a disposition by gift is an exception to the general rule of Section 1042(e)(1) that any disposition triggers gain.
The Section 1042(e)(1) general rule provides: “If a taxpayer disposes of any qualified replacement property, then, notwithstanding any other provision of this title, gain (if any) shall be recognized to the extent of the gain which was not recognized under subsection (a) by reason of the acquisition by such taxpayer of qualified replacement property.”
We would urge the IRS to rule publicly that no gain is recognized by the transferor. Hopefully, such ruling(s) would cover different scenarios, such as when the transferor retains the charitable remainder trust’s annuity or unitrust amount (the income interest) or names someone else to receive such interest.
The rules are generally quite strict that dispositions of such stock trigger gain.
Contributions to partnerships do not normally trigger gain, but in an ESOP context, even contributions of public stock (reinvestment securities) to a partnership trigger gain. ((See Revenue Ruling 2000-18.))
We don’t readily find the IRS ruling on the issue, but it may be a concern that gain is triggered when there is disposition by the recipient of the gift. There’s an exception to gain recognition when the disposition is by gift, but is the unrecognized gain triggered upon disposition by the recipient of the gift even when the recipient is exempt?
The concern is the reach of the statute that says, subject to few exceptions, that when the taxpayer disposes of such stock, gain is triggered. ((Section 1042(e)(1).) It would be an anomaly, but could the exempt entity (charity or CRT) have taxable gain when it sells donated, publicly traded reinvestment securities?
The language at stake here as to a CRT is that Section 664(c) says under the heading of “Income Tax” that any disposition by a CRT shall not be subject to any tax imposed by this subtitle, and then under “Excise Tax” says any unrelated business income shall be subject to a 100% tax. The language regarding “this subtitle” would seem to override the language of Section 1042(e)(1) given it is in the same “subtitle.” Yet Section 1042(e) also states that notwithstanding any other provision in this title, gain will be recognized. So one could argue its language overrides.
It has been opined that gain upon disposition by the CRT following transfer of the qualified replacement stock to the trust would be exempt; i.e., the exempt status of the trust should make the charitable remainder trust’s gain tax-free. “Coupling ESOPs with Charitable Remainder Trusts,” Part 2 of 2, Louis H. Diamond, Planning Giving Design Center, 2016. See also Mr. Diamond’s discussion as to the possibility of the shareholder funding a CRT and then the trustee independently deciding to fund an ESOP.
While we would argue the exempt status of the CRT under Section 664 should prevail, could Section 1042(e)(1) be a concern here?
A possible work-around may be to invest in short-term debt instruments rather than stock. The argument would be that if the sale of public stock triggers taxable gain despite the entity’s exempt status under Sections 501 or 664, the mere collection of a debt instrument at its maturity shouldn’t be construed as a disposition.
As to a private foundation or public charity, generally we could discuss the same issue: Is the gain inside the entity tax-free because of the entity is exempt, or could the language of Section 1042(e)(1) override and cause recognition of the gain?
We generally believe there is no taxable gain upon sale by the CRT, charity, or private foundation but these very important issues need further clarification from the IRS.
We would encourage the IRS to rule publicly in an ESOP context on issues of transfers to charity and CRTs, and confirm that sales by the exempt entity do not trigger taxable gain, despite the worrisome language in Section 1042 that generally says dispositions of such stock trigger gain.
Charities and CRTs receive gifts of listed securities frequently, and they’re sold without reporting gain because of the organization’s exempt status. The IRS should confirm that Section 1042(e)(1) doesn’t trigger gain, or warn taxpayers if this a problem!
In summary, there is increased interest in ESOPs. Our emphasis in connection with ESOPs is to encourage formal clarification as to transfers of replacement assets to and sales by exempt transferees. The exempt transferee may be a charity exempt under Section 501 or charitable remainder trust exempt under Section 664(c).
We would encourage IRS formal rulings and/or clarifying amendments to the tax code confirming that Section 1042 does not apply to trigger gain to the transferor when (usually) publicly traded stock acquired in an ESOP context is disposed of in a non-sale transfer to a public charity, private foundation, or charitable remainder trust. Technically, this would be a formal confirmation of the scope of the gift exception with respect to gain that is normally triggered by disposition.
We’d also encourage IRS formal rulings and/or legislative clarifying amendments confirming that following such a transfer, sale by the exempt entity does not trigger tax under the worrisome language of Section 1042(e)(1).
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Robert L. Rojas, CPA is the owner Rojas & Associates, CPAs, Los Angeles, Newport Beach, and Sacramento.