Frequently Asked Questions

Employee Ownership FAQs

Common questions about employee stock ownership plans (ESOPs), employee ownership trusts (EOTs), and other forms of employee ownership, from the basics to technical topics.

This FAQ is written primarily for business owners, managers, and advisors involved in setting up or running an employee ownership plan. If you're an employee at an ESOP company looking to understand your own benefits and rights, see our articles on Working at an ESOP Company and The Rights of ESOP Participants.

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Can a company use its ESOP to acquire another company and get the seller Section 1042 treatment?

It is possible for a company (the "acquirer") to use its ESOP to buy the stock of another company (the "target") and have the target's owner qualify for Section 1042 treatment. There are different ways to do this and different issues involved. A few general criteria must apply, however:

1. The stock in the acquirer must have been held by the ESOP for at least three years. The owner of the target company must have held the securities he or she is selling to the ESOP (or other securities that qualify through "tacking" provisions that treat them as equivalent, such as ownership of preferred shares converted to common in the same company or partnership interests that have been converted to shares in a C corporation) for at least three years prior to the transaction.

2. The seller must sell to an ESOP in a C corporation.

3. The transaction will need to meet the rules of a Section 368 merger. Most importantly, this means that the target company is acquired for shares in the acquiring company.

4. The transaction must meet the "continuity of interest" and "continuity of business" tests. These tests essentially say that the seller's company must continue in operation as part of the acquiring company for at least two years and that any shareholders in the companies being merged must retain at least a 50% ownership interest for at least two years. The 50% is measured as a percentage of the ownership interest sold to the acquirer (if I sold all my stock, I would have to retain shares in the new company equal to 50% of what I sold for two years).

The ability of the seller to get the Section 1042 tax deferral requires that the sale be at an ESOP in a C corporation. The mechanics of the sale depend on whether the ESOP company is a C and the buyer is a C, or there is a conversion to C by the company whose ESOP purchases the shares.

There are a few possible scenarios:

The Seller is a C and the buyer is a C. In this case, the seller exchanges his or her shares for the shares of the buyer. The seller then sells these shares to the acquirer’s ESOP. Because the seller’s ownership of shares in the target should be counted for the three-year holding period, it should be possible for this transaction to qualify for the tax deferral.

In the second scenario, the seller is an S corporation and the ESOP acquirer is a C corporation. The target company would first convert to C status prior to the sale and then exchange stock with the acquiring company.

The vast majority of acquisitions done by ESOP companies, however, are done by ESOP corporations that are 100% employee owned. These companies do not pay corporate income tax and often accumulate significant assets to help finance the purchase. If the acquiring company is an S corporation, then the seller cannot get section 1042 tax treatment by selling to the ESOP in the acquiring company. In order to get this tax treatment, the most common approach would be for the target company to set up its own ESOP first. If it is an S, it would convert to C. The ESOP would be paid for by the acquiring company, which would also make the financing available for the target compan’s ESOP to purchase the seller's shares. Once that transaction is completed, the ESOP in the target and the ESOP in the acquiring companies merge. This is the most common approach used for these transactions.

For more information on using an ESP for acquisitions, see Acquisition Strategies for ESOP Companies. See also see the NCEO’s Being Acquired by an ESOP Company Toolkit.

Link to this FAQ Topic: Tax Benefits to the Seller & Company