New IRS Regulation Could Make ESOP Section 1042 Acquisitions Easier

Section 1042 of the Internal Revenue Code allows sellers of closely held companies to defer taxation from any gain to the extent that they reinvest the proceeds of the sale in domestic stock and bonds. The law says the sale must be not to just any ESOP, but the ESOP of a company whose shares the sellers have owned for at least three years and that owns or will own after the sale 30% or more of the company's shares. That means that if the owner of Joe's Smokehouses ("the target") wants to sell to Bill's Barbecue Restaurant's ESOP ("the acquirer"), the sale wouldn't qualify for section 1042. But what if the target merged into the acquirer, then the target's owner's sold to the acquirer's ESOP?

Until recently, that would have met the 1042 rules (ownership of the shares exchanged in the merger would "track"), but the transaction would fail because IRS guidelines said that there had to be a "continuity of interest" for the owner of the target's shares in the acquirer's company. If two companies merged, the exchange of shares from one to the other had been considered taxable if the transaction looked like an actual sale (the target's owner sold to the acquirer for the acquirer's stock, then turned around and sold those shares) rather than a merger (the target's owner held on to the shares for a couple of years). For Bill's to buy Joe's and get Joe's owner 1042 treatment, a reverse merger was the generally recommended approach. Here, the acquirer first merges into the target. An ESOP is set up in the combined company to buy the seller's shares. The financing for the transaction may actually come from the acquirer. In a common model, the target and acquirer will then do business under the acquirer's name.

Under regulations issued by the IRS on January 28, 1998, this transaction may be greatly simplified. The IRS has indicated that if the acquired company shares are sold to an "unrelated" third party, rather than the acquirer, the continuity of interest requirements are met. While the regulations do not specifically include ESOPs, ESOPs have been considered an unrelated party for IRS purposes in the past. For instance, a partial sale to an ESOP qualifies for capital gains treatment as a sale to an unrelated third party. If the more direct approach these regulations appear to make possible stand up, it could make it much simpler for companies to use ESOPs to buy other companies. Because the ESOP issue has not been tested, however, companies should proceed with caution.