Executive Summary

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Employee Stock Ownership Plans (“ESOP”) offer a variety of liquidity, tax and operating benefits to business owners who are contemplating a sale or partial sale of their business. This article is intended to serve as a reference for business owners who are contemplating forming an ESOP, and their trusted advisors, who wish to understand a particularly effective tax deferral strategy that reinvests sale proceeds in 1042 qualified replacement property (“QRP”) portfolios. The opportunity to defer capital gains tax can make an ESOP very attractive for business sellers. The challenge business sellers face is how to roll over the sale proceeds in a manner that meets 1042 qualified replacement property rules, yet aligns with their growth, income and liquidity needs. Moreover, it is important that the seller evaluate available 1042 QRP rollover options up front, in order to understand their implications for the ESOP’s overall implementation.

There are several QRP options worth examining:

  • Floating Rate Notes
  • Passive Corporate Bonds
  • Passive Blue-chip Equities

In this article, we survey these strategies and compare their relative benefits. In doing so, we urge investors to bear in mind the FACTS (Fees, Access, Complexity, Taxes and Search) when making an investment decision. Our experience suggests that the vast majority of taxable family offices and high net worth individuals should focus on strategies with low costs, high liquidity, simple investment processes, high tax-efficiency, and limited due diligence requirements. This approach flies in the face of the complex and expensive 1042 QRP investment solutions typically offered in the marketplace. Our analysis suggests that floating rate notes are often the least effective investment option. Instead, investors should focus on the passive solutions, with a special emphasis on passive equity strategies, which can be customized to maximize the benefits of the tax-deferral opportunity inherent in 1042 transactions.

Introduction

When we set out to research the range of qualified replacement property investment strategies available in the marketplace today we had one mission in mind:

  • Identify the most effective way to capture the after-tax value that a 1042 qualified replacement property enables selling shareholders to achieve through an ESOP.

Our work was guided by two core beliefs:

  • The solution must serve the needs and best interests of our clients; and
  • Implementation and costs must be transparent so clients have confidence in the solution.

One might ask at the outset: How did Alpha Architect, a systematic investment shop focused on value and momentum equities, end up developing 1042 QRP solutions? The short answer is that we needed to help one of our business partners, who had a family member who wanted to sell shares in a large ESOP-owned company. Selling the shares to the ESOP was the easy part. The hard part was identifying the appropriate qualified replacement property that would both satisfy 1042 QRP regulations and simultaneously maximize the one-time deferral opportunity afforded by the esoteric IRS tax law.

Our research into alternative 1042 QRP strategies was initially challenging. This is not a transparent market—even for finance professionals. I have 20+ years of experience as a financial advisor to corporations and individuals and consider myself a sophisticated capital markets participant. In addition, the Alpha Architect team is filled with professionals who have master’s and Ph.D. degrees in Finance.. Despite our unique vantage point, our efforts to find publicly available information about 1042 QRP rollover strategies yielded only a handful of approaches. Each of these solutions, provided by investment banks or trust companies, was like an onion: Each time we thought we understood one layer, we found another layer—with fee, tax, and complexity implications—that complicated our understanding. If we cannot easily understand the costs of these solutions as experienced finance professionals, then what chance does the average business owner have when it comes to assessing 1042 QRP options?

Why are 1042 QRP solutions so limited?

We hypothesize that this is a niche, opaque, old-line business that is dominated by a few industry players whose solutions entail high-margin products that are sold to business owners seeking to pursue 1042 elections. Once providers of these types of financial products identify the most profitable approach, even if not necessarily the best for their clients, they may have an incentive to advance it to the exclusion of others. Further, there is a certain amount of tax risk involved in purchasing a qualified replacement property: Get it wrong, and your silent partner, the IRS, might become your new special friend. Finally, the definitional constraints on QRP, combined with the functional needs of the purchaser, create an investment asset profile that is relatively narrow. To us, at Alpha Architect, these conditions are a clarion call to innovation! We addressed this call to action by pioneering our own transparent and affordable 1042 QRP solution that you can read about here.

The sections of this article are organized as follows:

  • Summary of ESOPs and the 1042 deferred tax election rules—including the implementation of a QRP rollover.
  • Specific investment attributes that would maximize the value of any asset purchased and held within the definitional constraints of a 1042 qualified replacement property.
  • Survey of the principal rollover strategies prevalent in the marketplace, as well as other techniques associated with their implementation to achieve common seller objectives.

We conclude our work with a numerical ranking of the strategies reviewed, as well as offer our further insights into the current nature of the ESOP implementation advisory landscape. We hope to empower business owners to take back control of their hard-earned wealth, through the proactive selection of the most appropriate 1042 qualified replacement property investment strategy for their needs.

Section 1. Formation of Section 1042-compliant Tax-Deferred ESOPs

Congress put section 1042 tax incentives in place in 1984 to encourage the formation of ESOPs, which are qualified employee retirement savings plans. Structures resembling ESOPs have been in use since the late 1950s. Subject to meeting certain conditions, a shareholder who sells qualified securities to an ESOP through a 1042 election incurs no taxable gain on the sale. In many states,(1) the combined state and federal long term capital gains tax rate can be as high as 33%. The ability to invest and compound wealth that would otherwise have been taxed away can create a powerful incentive to implement a 1042 ESOP election.

The selling shareholder’s personal situation and wealth management objectives are foremost among the many factors that underlie whether or not to elect a Section 1042 sale. Although the ability to defer taxes adds significantly to an ESOP’s attractiveness for most sellers, the 1042 election entails significant time and resources. These can include accounting, legal and advisor fees, which vary according to the specific 1042 QRP strategy employed by the selling shareholder. Before examining later in this paper prevalent 1042 qualified replacement property investment strategies available in the market, we provide a brief overview of principal requirements for effecting such transactions.

Several important conditions must be met in order for the sale of qualified securities to an ESOP to achieve tax-deferred treatment:

  • The selling shareholder must file appropriate notices(2) with the IRS associated with a 1042 sale election;
  • The Company whose shares are being sold to the ESOP must be a domestic C-Corp(3) whose shares are closely held, i.e., with no stock outstanding that is “readily tradeable” on an established securities market;
  • Immediately after the sale,(4) the
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