ESOPs, AMT, and Section 1042: Confusion Abounds

A number of sellers to ESOPs, as well as their advisors, are rethinking whether to take advantage of the tax-deferred rollover opportunity Section 1042 of the Internal Revenue Code provides for sales of stock to ESOPs in C corporations that end up with at least 30% of the company's shares. The reasoning is that with the lower (15%) federal capital gains tax rate, paying the tax may be a reasonable trade-off for people who have problems with the various restrictions the law imposes, most notably on what sellers can invest in (no mutual funds, government bonds, etc.) and/or who can get stock in the ESOP from the sold shares (the seller, the seller's family, and any other 25% shareholders and their immediate family are not eligible).

Now some advisors are saying this is bad advice because sellers will be in an alternative minimum tax (AMT) situation in many cases. Some are saying that if you land in AMT for whatever reason, taxes might even approach ordinary income tax levels. The problem is not as serious as that, but there can be some added taxes from the AMT, enough for some people to choose the Section 1042 rollover after all.

Under the AMT, a taxpayer makes two tax calculations. The first one is done in the usual manner, deducting such things as state and local taxes, charitable contributions, etc. Some income, such as gains on exercises of incentive stock options where the stock has not yet been sold, is excluded from income. Then the taxpayer does an AMT calculation. Various items that were taken as deductions or exclusions (such as incentive stock option exercise gains and state and local taxes) are added back to income. From this total, the taxpayer excludes a specific amount, depending on filing status (currently $58,000 for a joint return). The remaining amount is divided into ordinary income and capital gains income. Ordinary income is taxed at 28%; capital gains at 15%, just as in non-AMT calculations. If tax is higher under AMT, the AMT tax is paid. The difference between the two tax calculations is a credit that can be applied in future years when ordinary income tax yields a higher amount than AMT.

Here is where the ESOP rub can come in. Every $4 in capital gains eliminates $1 in the exemption. So at the $58,000 level, $232,000 in capital gains would eliminate the exemption altogether. That $58,000 now must be taxed at the 28% AMT level. So another $16,240 would be paid in taxes. In addition, if the taxpayer is in a state where the capital gain is taxed as income, then the deduction for that tax normally taken under the non-AMT tax calculation does not apply. So 28% of the state tax would be added as well.

Here's an example. Say John has $200,000 in AMT reportable income subject and $3 million in capital gains from the sale of stock to an ESOP. John lives in a state with a 5% tax on the gain from the sale. John has to pay AMT because his AMT tax calculation is higher than his non-AMT calculation.

Normally, John could take a $58,000 AMT exemption, but it is wiped out by his capital gains. So that adds $16,240 to his taxes. In addition, John cannot take the 5% deduction on the state tax he paid on the $3 million gain. So he must now pay an additional 28% of 5% x $3 million ($42,000). So there is a total of $60,240 more in tax due to AMT, or an additional 2% over the normal 15% capital gains rate.

Of course, the AMT is a complex tax, and each case needs to be looked at individually. In a very high tax state, or one with both a state and local income tax, the net effect could be to raise the effective capital gains rate back to near the 20% rate it had been before. Of course, people living in these states would normally face a non-AMT tax of 15% plus the state and local tax, and that could be well over 20%. Most of these people will want to take the deferral offered by Section 1042 anyway.

Needless to say, the AMT is a complex issue. But readers should be cautious about advice they may receive on this. Make sure the people really understand the issues thoroughly and consider getting a second opinion. A good guide to these issues in general is in Kaye Thomas's Capital Gains, Minimal Taxes. Thomas provided input for this article (but the conclusions are ours), and has a succinct explanation of the AMT and capital gains issue on his Web site.