If you think the 1042 election could be right for you, it is time to evaluate investment details. To successfully complete a 1042 election, the Employee Stock Ownership Plan (ESOP) seller must invest in Qualified Replacement Property (QRP) within a fifteen-month window. This window opens three months before the transaction closes and stays open for twelve months after. You can think of QRP as equity (stocks) and debt (bonds) of U.S. operating companies. There are nuances to this test, but hundreds of publicly traded U.S. companies meet these criteria annually (think of blue-chip stocks, ranging from Apple to PepsiCo). Given this range of eligible investments, ESOP sellers are wise to consider building out their U.S. large cap stock portfolio with QRP purchases. Also, the dollars used to purchase QRP do not necessarily need to be the actual sales proceeds (other cash, whether on-hand or borrowed can be used to fund QRP purchases).
To be considered QRP, the stock or bond purchased must be from a U.S.-domiciled company that derives no more than 25% of its revenue from passive activities, and at least 50% of the company’s assets must be used in an active trade. It is sometimes easier to consider what does not qualify: REITs, foreign stocks, government bonds, mutual funds and ETFs are excluded.
Because it is possible to buy a diversified basket of U.S. Large C ap stocks that meet 1042 criteria, most ESOP sellers electing 1042 often attempt to satisfy their election by rolling 100% of their ESOP sale proceeds into these stocks. However, other portfolio considerations, liquidity constraints and longer-term diversification goals drive some ESOP sellers to consider purchasing a specific type of bond: the Floating Rate Note (FRN).
FRNs issued by eligible U.S. companies typically have long durations (35-50 year maturities) and coupon rates that reset quarterly, which protect buyers from interest rate and duration risk. These characteristics, along with the underlying credit rating of the bond, generally allow the FRN owner to borrow anywhere from 75-90% of the FRN’s face value on a margin loan. This unique borrowing capability allows the ESOP Seller to buy FRNs to satisfy 1042 election requirements and then borrow against them to create a diversified portfolio of stocks, bonds, and private capital investments. Additionally, the ability to borrow against FRNS is potentially critical to ESOP sellers who are providing seller financing to the ESOP. For example, if you sell your company for $25,000,000 and receive only $5,000,000 of cash upfront, you are left with a $20,000,000 gap in your ability to acquire QRP during the fifteen-month rollover window. Although there are many risks to consider before determining a strategy, a seller can purchase the entire $25,000,000 of QRP by buying $5,000,000 of stocks and FRNs with cash, then borrowing against those assets to purchase the remaining $20,000,000 of FRNs.
Our preference is U.S. Large Cap stocks, but every situation is unique, and many ESOP sellers take a hybrid approach. These strategies carry substantial risk that should be discussed in greater detail with your financial planner, but the more liquidity the ESOP seller receives upfront, the more flexibility they have to design an ideal 1042 strategy. Additionally, if you are older, and therefore “closer to the end of your plan,” then the 1042 strategy and eventual step-up in cost basis may be even more compelling.
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