1042 Overview

Some Employee Stock Ownership Plan (ESOP) sellers are eligible to defer capital gain taxes on ESOP transactions by investing their sales proceeds into Qualified Replacement Property (stocks and bonds of certain U.S. companies).  The technical name of this election is a 1042 exchange, which refers to the specific Internal Revenue Code that permits the deferral (Section 1042 of the Code is similar to other “like-kind exchanges” such as a 1031, which allows real estate investors to defer capital gains taxes on certain sale and reinvestment transactions).  Under the current tax code, if the Qualified Replacement Property is held until death, the estate can liquidate the Qualified Replacement Property after taking a step up in cost basis, thereby eliminating capital gains taxes on the original transaction. 

The power of this election is highlighted below with a simple $25,000,000 exit example.  Depending on your state of residence, deferring taxes could save upwards of 23.8%, which amounts to several million dollars of potential savings if electing 1042 is right for you: 

With a 1042 election, the entire $25,000,000 of proceeds is retained, amounting to $7,187,500 of savings in this example.  Additionally, because the ESOP will likely pay out in multiple tranches (an initial tranche payment in year one and a note, which is subsequently paid off over several years, depending on business cash flow), you could be subject to an “underpayment penalty.”  An annual underpayment penalty is an interest charged assessed by the IRS on any tax liability associated with capital gain above $5,000,000 on an outstanding installment note obligation.  You can think of this as an additional tax drag for not electing 1042, and this is something to discuss with your CPA and financial planner.  

There are other risks and considerations to evaluate before making a 1042 election, but it all starts with two questions: Is ESOP the right choice for me?  Am I eligible for a 1042 election?  According to the National Center for Employee Ownership, you are initially eligible for a 1042 election if the following are true:[1] 

  • Your company is a closely held C corporation; 
  • You have held the company stock for at least three years; 
  • Your shares were not acquired from a compensatory plan (e.g., a stock option plan); and 
  • You must sell at least 30% of the business to the ESOP. 

Additionally, the Secure Act 2.0 is scheduled to increase 1042 election eligibility; beginning in 2028, S corporation shareholders will have the ability to defer 10% of their sale proceeds.  Lastly, some owners find it advantageous to convert to C-corporation status, then sell to the ESOP, but the tax consequences of conversion need to be evaluated against the potential benefits of a 1042 election.  These items and how the 1042 exchange fits into your broader goals should be discussed with your financial planner. 

[1] Clarkson, C., Gilbert, R., Jacobsen, S., Rosen, C., Ryan, P., & Serwinski, K. Selling to an ESOP. Oakland, CA: National Center for Employee Ownership, 2020. 


© 2025 Advisory services offered by Moneta Group Investment Advisors, LLC, (“MGIA”) an investment adviser registered with the Securities and Exchange Commission (“SEC”). MGIA is a wholly owned subsidiary of Moneta Group, LLC. Registration as an investment adviser does not imply a certain level of skill or training. The information contained herein is for informational purposes only, is not intended to be comprehensive or exclusive, and is based on materials deemed reliable, but the accuracy of which has not been verified. 

Trademarks and copyrights of materials referenced herein are the property of their respective owners. Index returns reflect total return, assuming reinvestment of dividends and interest. The returns do not reflect the effect of taxes and/or fees that an investor would incur. Examples contained herein are for illustrative purposes only based on generic assumptions. Given the dynamic nature of the subject matter and the environment in which this communication was written, the information contained herein is subject to change. This is not an offer to sell or buy securities, nor does it represent any specific recommendation. You should consult with an appropriately credentialed professional before making any financial, investment, tax or legal decision. An index is an unmanaged portfolio of specified securities and does not reflect any initial or ongoing expenses nor can it be invested in directly. Past performance is not indicative of future returns. All investments are subject to a risk of loss. Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets. These materials do not take into consideration your personal circumstances, financial or otherwise. 

Additional articles