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Focus on Operational Issues

Allocation Restrictions Triggered by a Section 1042 Sale to an ESOP (Part 1)

Nancy Dittmer

March 21, 2010

(Nancy Dittmer)There is much speculation that the capital gains tax rate may increase at some point in the future. If so, we may see an increasing number of tax-deferred sales to an ESOP (i.e., Section 1042 sales).

A 1042 sale does trigger some unique operational issues that will be summarized here. As with other ESOP operational issues, there are areas of uncertainty, so consultation with your own ESOP advisor on your situation is recommended.

Code Section 409(n) provides that certain employees are prohibited from receiving:
  1. an allocation of the shares acquired in a 1042 transaction
  2. an allocation in lieu of such 1042 share allocations
  3. earnings on the 1042 shares

The employees who are subject to these prohibitions (the "prohibited group") include:
  1. the selling shareholder
  2. an individual who is related to the selling shareholder (although there is an exception for limited allocations to lineal descendants)
  3. any more-than-25% shareholder of the company

The nonallocation period for the selling shareholder and family members begins on the date of the 1042 sale to the ESOP and ends on the later of the date that is 10 years after such sale or the date on which the last 1042 shares are released from the unallocated suspense account and allocated among participant accounts. The prohibition on allocations of 1042 shares to a more-than-25% shareholder generally extends indefinitely.

A practical consequence of these rules is that any 1042 shares must be tracked separately in the plan administration process. This separate tracking is needed to ensure that not only are the 1042 shares allocated correctly when first purchased or released from the unallocated suspense account but also that the shares are allocated correctly when reallocated either as forfeited shares or recycled shares. There may also be separate tracking of the cash or other investment accounts within the ESOP to ensure that allocations of items such as dividends or other earnings on the 1042 shares are not allocated to the accounts of the prohibited group.

The above general summary leads into many questions, including:
  1. Do 1042 shares ever lose their taint as 1042 shares?
  2. What is the definition of family for purposes of these provisions?
  3. What happens when you have multiple sellers?
  4. How does the exception for allocations to lineal descendants work?
  5. When and how does one determine whether an individual is a more-than-25% shareholder?
  6. What is an allocation in lieu of 1042 shares?
  7. How does a subsequent S election by the plan sponsor affect these rules?
  8. What are the consequences of making a prohibited allocation?

With respect to the first question, as long as the shares remain in the ESOP trust, the 1042 taint also remains with those shares. Thus, as alluded to above, the shares of terminated participants may be re-allocated to active participants as either forfeited or recycled shares, but they will continue to be treated as 1042 shares and as such cannot be allocated to the prohibited group. Alternatively, if the shares are distributed to the former participants and the ESOP subsequently repurchases such shares, then those shares would no longer be considered 1042 shares. Note that this does require that the shares actually leave the trust, even if for only a moment.

The remaining questions will be addressed here in future columns.

Author biography and other columns in this series

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