The SECURE 2.0 Act of 2022 (SECURE 2.0) made numerous changes to the complex web that makes up U.S. retirement plan laws. Of interest to S corporations that may be considering an employee stock ownership plan (ESOP) is the expansion of Section 1042 of the tax code to permit a 10% tax deferral for certain sales to S corporation ESOPs.
Section 1042 has, for many years, allowed the owners of non-publicly traded C corporation stock to defer capital gains tax on up to 100% of proceeds from a sale to an ESOP if: (1) the ESOP owns 30% or more of the stock after the sale; and (2) the seller reinvests the proceeds in stocks and bonds of U.S. operating companies (referred to as “qualified replacement property” or QRP). QRP is generally defined under Section 1042(c)(4)(A) as any security issued by a U.S. operating company that does not have more than 25% passive income and is not related to the corporation being sold to the ESOP.
Section 114 of SECURE Act 2.0 amends Section 1042 to give S corporation owners a similar tax deferral opportunity. Effective sales to ESOPs that occur after December 31, 2027, S corporation owners may now avoid some capital gains using Section 1042, but the deferral opportunity is limited. Unlike C corporation, which may defer 100% of the gain, S corporation owners are limited to a deferral of 10% of the gain. The other requirements under section 1042 also apply to S corporations, including the requirement that proceeds from the sale to the ESOP be available within 12 months. Like with C corporations, this limits a seller’s ability to receive a promissory note as part of the sale.
While this new benefit is limited, it still provides some relief from capital gains tax for S corporation owners, especially if immediate access to the cash proceeds from the ESOP are not a primary concern. If you have any questions about Section 1042 or ESOPs in general, please contact any of Bricker Graydon’s Employee Benefits team.
