There’s a whole acronym soup of tax and planning strategies available to business owners—and some of the more complicated ones require a great deal of experience to execute well.
One strategy that can be very advantageous to business owners is the 1042 exchange. In this brief article, we will walk you through the broad outlines of what this strategy entails and how business owners can use it to plan for the next stage in life.
1042 Exchange Basics
Named for Section 1042 of the tax code, this strategy gives beneficial tax treatment to your capital gains when you sell your company stock to an ESOP, or Employee Stock Ownership Plan.
Once you sell your stock to the plan, you have the opportunity to not only defer capital gains but diversify your holdings by investing the cash you receive from the sale in Qualified Replacement Property (QRP).
If you don’t sell those securities, the QRP becomes part of your estate, and you avoid capital gains taxes altogether.
In short: you sell your shares to an ESOP, which provides a tax benefit right away. You reinvest the cash from that sale in qualified securities for deferred capital gains later, or you avoid them altogether.
What is Qualified Replacement Property?
There are some nuances, but generally QRP can be stocks and bonds of U.S. operating companies—you can’t buy international shares or, for example, Treasury Bonds. Any amount not invested in QRP within 12 months after the sale will be taxable.
As you can see, this implies that you should carefully plan your QRP portfolio so that you remain within the risk parameters and needs of your overall wealth plan. These portfolios also tend to be held for long periods of time, so the portfolio you choose should be one you want to hang on to.
Why Would You Go Through This?
Depending on your situation, a 1042 exchange and investment in QRP can provide you with tax benefits, and significant risk reduction.
It’s a complex vehicle that we believe benefits from a significant amount of experience and care, which is why we recommend working with someone who’s done a lot of these transactions. At Stembrook, we’ve helped many business owners assess their opportunities and mange liquidity events, and we can offer a personal assessment and objective guidance in making these types of decisions.