ESOP Operational Issues
Allocation Restrictions Triggered by a Section 1042 Sale to an ESOP (Part 1)
March 21, 2010There 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:
- an allocation of the shares acquired in a 1042 transaction
- an allocation in lieu of such 1042 share allocations
- earnings on the 1042 shares
- the selling shareholder
- an individual who is related to the selling shareholder (although there is an exception for limited allocations to lineal descendants)
- any more-than-25% shareholder of the company
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:
- Do 1042 shares ever lose their taint as 1042 shares?
- What is the definition of family for purposes of these provisions?
- What happens when you have multiple sellers?
- How does the exception for allocations to lineal descendants work?
- When and how does one determine whether an individual is a more-than-25% shareholder?
- What is an allocation in lieu of 1042 shares?
- How does a subsequent S election by the plan sponsor affect these rules?
- What are the consequences of making a prohibited allocation?
The remaining questions will be addressed here in future columns.