At a glance
- What it is
- Selling company stock to an ESOP, a qualified retirement plan for your employees, and electing under IRC §1042 to defer the gain by reinvesting in U.S. operating company securities.
- What it saves
- Federal capital gains tax and the 3.8% net investment income tax on the sale, deferred until you sell the replacement securities, or never if you hold them until death.
- Best fit
- Owners of profitable companies with strong management who want employees to own the business.
- Main catch
- Section 1042 applies to C corporation stock, and the ESOP must own at least 30% after the sale.
- Price
- Set by an independent appraisal. An ESOP can’t pay more than fair market value.
Key takeaways
- Selling to an ESOP means selling company stock to a trust for your employees at fair market value, set by an independent appraisal.
- It fits owners of profitable companies with strong management who want employees to own the business and keep it local and independent.
- In the illustrative $10 million sale, a Section 1042 election defers about $2.14 million of federal tax, keeping the full $10 million invested.
- The catch: Section 1042 applies to C corporation stock, the ESOP must own at least 30% afterward, and selling replacement securities triggers the tax.
The numbers
Picture an owner of a C corporation who sells all of the company’s stock to an ESOP for its appraised value of $10 million. Their basis in the stock is $1 million, so the gain is $9 million. Within 12 months, they reinvest the proceeds in stocks and bonds of U.S. operating companies and elect Section 1042.
For illustration purposes. Tax law may change, which may change these calculations slightly.
Personal tax on the sale (federal)
| Regular sale | ESOP + §1042 | |
|---|---|---|
| Sale price | $10,000,000 | $10,000,000 |
| Gain ($10M less $1M basis) | $9,000,000 | $9,000,000 |
| Capital gains tax and NIIT (23.8%) | $2,142,000 | $0 now |
| Amount left to invest | $7,858,000 | $10,000,000 |
With the rollover, about $2.14 million of federal tax is deferred and the full $10 million is invested for the owner. The replacement securities carry the old $1 million basis. If they’re held until death, heirs generally get a stepped-up basis and the deferred gain is never taxed under current law. Oklahoma tax is figured separately.
Most ESOP sales are financed over time: the company borrows, often including a note back to the seller, and repays it with tax-deductible contributions to the ESOP. Some owners borrow against their replacement securities to get cash without selling them.
Could this strategy work for your business?
In a free tax analysis, your tax strategist checks whether it fits and what it could save, using your real numbers.
How it works
- Test feasibility. An ESOP works best for profitable companies with steady cash flow, enough payroll, and a management team that can run the business without you.
- Set up the ESOP and get an appraisal. An independent trustee and appraiser represent the employees and set a fair market price.
- Sell the stock. The ESOP buys your shares, usually financed with bank debt and a seller note.
- Reinvest within the window. Buy qualified replacement property, stocks or bonds of U.S. operating companies, from 3 months before to 12 months after the sale.
- Elect Section 1042. File the election and statements with your tax return for the year of the sale.
Who it fits
- Owners who want to reward employees and keep the company local and independent.
- C corporation owners, or S corporation owners willing to plan a conversion before the sale.
- Companies with roughly $1 million or more of steady earnings and strong management.
When it doesn’t fit
- Owners who want the highest possible price. A strategic buyer may pay a premium an ESOP can’t.
- Small or volatile businesses that can’t carry the acquisition debt.
The rules
- C corporation stock. Section 1042 applies to stock of a domestic C corporation that isn’t publicly traded. S corporations would need to convert first.
- Three-year holding. You must have held the stock at least three years, and it can’t have come from a company stock plan or option.
- 30% ownership. After the sale, the ESOP must own at least 30% of the company’s stock.
- No allocations to you or your family. Shares bought in a 1042 sale can’t be allocated to the seller, certain family members, or 25% owners.
- Selling replacements triggers the tax. Deferred gain is taxed when you sell the replacement securities. If the ESOP sells the shares within three years, the company can owe an excise tax.
Risks and costs to weigh
- Price and timing. The price is fair market value, often paid over years through a seller note. You carry the risk until it’s paid.
- Costs. Legal, trustee, appraisal, and plan administration costs, plus the ongoing work of running an ESOP.
- Repurchase obligation. The company must buy back shares from employees who leave or retire. That needs planning.
- A team effort. An ESOP needs an ESOP attorney, an independent trustee and appraiser, a lender, and your tax strategist.
How we handle it for clients
With a Cannon & Brown tax plan, we compare an ESOP with your other exit paths, model the after-tax result of each, and, if an ESOP fits, plan the C corporation timing, track the reinvestment window, and prepare the Section 1042 election. Because our technology keeps your books current, the numbers the appraiser and lender need are always ready. Your tax strategist reviews every recommendation.
Illustrative example. The owner and figures on this page are hypothetical, used to explain how the strategy works. They are not a client and not a promise of results. The example assumes a qualifying C corporation sale of 100% of the stock to an ESOP for $10 million, a $1 million basis held more than three years, full reinvestment in qualified replacement property, and the 20% capital gains and 3.8% net investment income tax rates. This page is educational and is not tax, legal, or investment advice for your situation; tax rules and limits change.
Common questions about selling to an ESOP
Can an S corporation owner use Section 1042?
Not directly. Section 1042 applies to stock of a domestic C corporation that isn’t publicly traded, so an S corporation would need to plan a conversion before the sale.
How long do I have to reinvest after selling to an ESOP?
You buy qualified replacement property, stocks or bonds of U.S. operating companies, from 3 months before to 12 months after the sale, then file the Section 1042 election with your return for the year of the sale.
Do I ever pay the tax deferred under Section 1042?
The deferred gain is taxed when you sell the replacement securities. If they’re held until death, heirs generally get a stepped-up basis and the deferred gain is never taxed under current law.
Will an ESOP pay as much as an outside buyer?
Not always. An ESOP can’t pay more than fair market value, and a strategic buyer may pay a premium an ESOP can’t. ESOP sales are also often paid over years through a seller note.
Brooks leads Cannon & Brown Tax Advisors, a forward-thinking tax firm serving business owners in Oklahoma and beyond. He builds year-round tax strategies that help business owners keep more of what they earn and reach their goals. More about Brooks
Free strategy finder
Find the tax strategies that fit you.
Answer six quick questions and see which of our 46 strategies may fit your business and your goals. About a minute, and your answers stay in your browser.
Find my strategies →Free tax calculators
What could a strategy save you?
- S corp
- Solo 401(k)
- Augusta Rule
- Hiring your kids
- Oklahoma PTE