Business owners who decide to sell their business to an Employee Stock Ownership Plan (“ESOP”) may have the option to fully or partially defer income taxes on the sale of their business. The selling business owner(s) can defer income taxes by taking the proceeds received at closing and completing a 1042 rollover (full or partial) which requires investing in what the IRS defines as Qualified Replacement Property (“QRP”). The QRP must be purchased within one year from the date of the business transaction. ESOP conversions are complex transactions; purchasing QRP is no different. Understanding the parameters and nuances are key to successful execution. In this article we explore the rules, risks, and strategies for purchasing QRP.
The IRS requires several conditions to be met for a security to be considered QRP:
- Must be a U.S. domiciled company.
- At least 50% of the U.S. based company’s assets must be used in the active conduct of a trade or business.
- No more than 25% of the company’s gross receipts can come from passive income sources.
Eligible investments include: Common stock, preferred stock, convertible bonds, corporate fixed rate bonds and corporate floating rate notes (“FRNs”).
Ineligible investments include: Bank CDs, U.S. government bonds, municipal bonds, foreign securities, ETFs, mutual funds, REITs and MLPs.
Full vs. Partial 1042 Rollovers
When selling to an ESOP, the seller typically receives some cash at closing, a seller’s note and sometimes, warrants. The selling owner(s) usually receive 20% – 40% of the total transaction amount in cash at closing. The remaining 80% – 60% is owed to the exiting owner(s) in the form of a seller’s note. Warrants are typically a part of the transaction when the seller’s note pays a below market interest rate. The structure of the transaction is important as it can impact how much cash is available from sale proceeds to purchase QRP.
- Full 1042 Rollover: A full 1042 rollover allows the exiting owner to defer 100% of the income taxes on the sale of the business. A full 1042 requires QRP to be purchased in the amount of the total transaction value regardless of how much cash was received at closing. To accomplish a full 1042 rollover, a substantial amount of debt must be used in structuring the QRP unless the owner has enough liquidity outside of the transaction to fund the purchases.
- Partial 1042 Rollover: A partial 1042 rollover allows the exiting owner to defer anywhere between 1% – 99% of the income taxes on the sale of the business. Due to potential installment sale tax consequences (which we will not cover in this article, but are important to be aware of), you will often see the amount of QRP purchased be just enough to avoid paying the underpayment penalty. This typically will require a significant amount of debt or cash from savings, but less than a full 1042 strategy.
QRP Investment Strategies
- Floating Rate Note (“FRN”) Monetization Strategy: The FRN strategy is frequently used when the selling shareholder elects to do a full 1042 rollover and/or the selling shareholder has the desire to avoid paying income taxes and needs liquidity. Typically, with the proceeds received at closing, 10% of the total transaction amount is invested in FRNs and then levered at a 90% loan to value (“LTV”) to reach the total transaction value. This can allow 100% deferral of income taxes on the sale of the business. The rest of the proceeds received at closing and from the seller’s note may be used at the discretion of the exiting owner. Usually, the FRNs do not generate enough income to cover the margin expense, and a constant influx of cash is required to cover the deficit.
- Equities & FRN/Corporate Bonds: Purchasing a mix of FRNs, corporate bonds and equities is often used in a partial 1042 strategy. The FRNs help provide stability in the portfolio and the equities offer the potential for long-term price appreciation desired by many investors. Additionally, depending on many factors which include, but are not limited to: the size of the margin balance, the dividend and coupon amount, margin rate, etc., it is possible to have the account be self-sufficient in paying off the margin expense.
- All Equities Portfolio: Typically, the all equity QRP portfolio is only used in a partial 1042 strategy and is smaller than the other strategies mentioned above. The reason the amount of QRP purchased is typically smaller is because less leverage is desirable with an all equity portfolio. With little to no leverage, this strategy should provide the highest level of price appreciation compared to the other two strategies, all other factors being equal. Also, with no margin loan, the owner of the QRP can sweep the dividends out of the portfolio and use them for their enjoyment.
Variables & Risks to Consider:
- Opportunity Cost: The FRNs purchased for a 1042 rollover are atypical and are structured for this specific circumstance. The opportunity cost lies with the lack of price appreciation in FRNs, and lower yields compared to those of corporate bonds.
- Amount of Leverage: With the exiting business owner(s) having capital tied up in a seller’s note and with the business usually taking on additional debt outside of the seller’s note to form the ESOP, a lot of debt/risk is often taken on simultaneously. In addition, to accomplish a full 1042, the exiting owner(s) could have to personally take on a substantial amount of debt to structure the QRP. Usually, we see business owners running their business and personal life with little to no debt and this can change very quickly. At this stage in your life/career it is worth exploring what level of risk brings you comfort/discomfort.
- Ability & Desire to Pay Off Margin Loan: A higher LTV may make more sense when the selling owner has no need for liquidity from the sale and is willing to use the seller’s note repayment proceeds to pay down/off the margin loan.
- Custodian Release Value: Blue chip equities, corporate bonds, & FRNs typically have 50%, 70% & 90% release values, respectively. Custodians have the ability to change release values and may reduce release values during periods of economic turmoil. When the market is in turmoil and collateral values are declining, the equity percentage of a marginable account could be considerably lower, compounding the potential to receive a margin call.
- Custodian Margin Rate: Similar to the release value, the custodian can change the margin rate. This can coincide with the lowering of the account’s release value.
- Ability & Desire to Cover a Margin Call: When an investor receives a margin call, they typically have a very short window to fund the account with additional capital. If the margin call is not met, assets in the account will be sold to cover it. Those assets will typically be sold at depressed prices, and a permanent loss of capital could be realized. In addition to the potential permanent loss of capital, the income taxes on the business sale that were deferred may be realized in proportion to the amount of QRP that was sold.
Electing to do a 1042 rollover can be complex and has many variables and risks involved. It is important to fully understand all of your options before making a decision. Otherwise, you could find yourself with more debt and risk than you desire. Should you have any questions, please reach out. Here at EBS, we are always happy to help.
This content is provided for informational and educational purposes only and should not be construed as investment, tax or legal advice. The strategies discussed herein may not be appropriate for all investors. The information is based on current laws and regulations, which may change. You should consult with qualified professionals before making any decisions regarding ESOP sales or QRP investments.