Gain on the sale of qualified securities to an employee stock ownership plan or to an eligible worker-owned cooperative is not recognized by any taxpayer except a C corporation — that is, if the taxpayer or the taxpayer’s executor elects not to recognize the gain and buys qualified replacement property within the replacement period defined below.
An executor may invest the proceeds of a deceased individual’s sale of qualified securities to an ESOP or EWOC in qualified replacement property within the replacement period. The executor also can designate as qualified replacement property any property acquired by the decedent for which a statement of purchase has not been made.
All of the following requirements must be met for a taxpayer to avoid recognition of gain.
- Immediately after the sale, the ESOP or EWOC must own at least 30 percent of each class of outstanding stock (other than nonvoting, nonconvertible preferred stock described in Internal Revenue Code Sec. 1504(a)(4)) or 30 percent of the total value of all outstanding stock of the corporation (other than such preferred stock). The option-attribution rules of IRC § 318(a)(4) apply in determining whether the 30 percent ownership requirement is met. Under those rules, a person who owns an option to acquire stock is treated as owning that stock.
Observation: If a person has an option to acquire stock from the employer, this increases the total amount of stock treated as outstanding and, thus, makes it more difficult for the ESOP or EWOC to meet the 30 percent ownership requirement.Example 1: Your client wants to sell 30,000 shares of the only class of Zewer Corp. stock to an ESOP that already owns 270,000 of the 1 million outstanding shares of Zewer stock. Immediately after the sale, the ESOP will own 300,000 shares of Zewer stock (or exactly 30 percent of the outstanding shares) and the 30 percent requirement will be met.
Example 2: The facts are the same as in Example 1, except that the chief executive of Zewer has an option to acquire 10,000 shares of Zewer stock. Zewer is treated as having 1,010,000 shares outstanding. Thus, the 30 percent requirement will not be met immediately after the sale, since the ESOP will own only 300,000 of the 1,010,000 outstanding shares of stock, or 29.7 percent.
- The selling taxpayer must file with the Internal Revenue Service a verified written statement by the employer whose employees are covered by the ESOP or EWOC, agreeing to the application of certain excise taxes on dispositions of stock by the ESOP or EWOC.
- The selling taxpayers must have held the qualified securities for at least three years at the time of sale.
A sale of qualified securities to an ESOP or EWOC by a dealer or underwriter in the ordinary course of its trade or business as a dealer or underwriter doesn’t qualify for non-recognition of gain.Non-recognition treatment applies only if the gain on the sale of the stock would otherwise have been long-term capital gain. This means that the sale of securities which otherwise would be treated as ordinary income is ineligible for non-recognition treatment. If the sale otherwise qualifies for non-recognition, the seller will still recognize long-term capital gain to the extent that the proceeds of the sale exceed the cost of qualified replacement property.
Example 3: Your client sells qualified securities with an adjusted basis to her of $100,000 to an ESOP for $300,000. The sale qualifies for non-recognition of gain. Your client buys qualified replacement property for $200,000 within the replacement period. Your client recognizes long-term capital gain of $100,000 on the transaction.
Qualified securities defined. Qualified securities are shares of common stock of the employer corporation issued by a domestic C corporation that has no stock outstanding. It is readily tradable on an established securities market, and also has no stock outstanding that is readily tradable on an established market for at least one year before and immediately after the sale by the shareholders to the ESOP or EWOC.
The qualified securities must not have been received by the seller from a qualified plan or under a right to acquire stock in connection with the performance of services under Code Sec. 83, or through an incentive stock option or an employee stock purchase plan — or through a qualified or restricted stock option (i.e., a form of stock option that no longer qualified for favorable tax treatment after May 20, 1981).
Qualified replacement property and replacement period defined. Qualified replacement property is any security issued by a domestic operating corporation that:
- Is not the corporation that issued the qualified securities that are being replaced, and is not a member of the same controlled group of corporations that issued the replaced securities; and,
- Did not, for the taxable year before the taxable year in which the replacement security was bought, have passive investment income, as defined for S corporation purposes in IRC § 1362(d)(3)(C), in excess of 25 percent of gross receipts. However, the stock of a bank or thrift institution would not be ineligible to be treated as qualified replacement property solely because the institution has passive income of more than 25 percent of its gross receipts for the preceding year.
Securities issued by a government or a political subdivision are not eligible to be treated as replacement property. Also, certificates of deposit issued by a financial institution are not qualified replacement property. An exchange of stock for a certificate of deposit would be taxable in an otherwise tax-free reorganization, and the Internal Revenue Service says that Congress intended to make the ESOP and EWOC non-recognition rules consistent with the reorganization rules.A corporation is an operating corporation if more than 50 percent of its assets were used in the active conduct of a trade or business when the securities were bought or before the close of the replacement period. The term operating corporation includes insurance companies and banks, including mutual savings banks, building and loan associations, savings and loan associations, and cooperative banks.
If the corporation issuing the qualified replacement property owns stock representing control of one or more other corporations, or if one or more other corporations own stock representing control of the corporation issuing the qualified replacement property, then all of those corporations will be treated as one corporation in determining whether a corporation is a domestic operating corporation and whether the corporation that issued the qualified replacement property also issued the qualified securities.
The replacement period is the period beginning three months before the sale of the qualified securities and ending 12 months after the sale.
Statement of election not to recognize gain. An election not to recognize gain on the sale of qualified securities to an ESOP or EWOC must be made on a statement of election. The statement of election must be attached to the taxpayer’s income tax return filed on or before the due date (including extensions of time) for the taxable year in which the sale occurs. Once made, the election cannot be revoked.
The statement of election must contain all of the following information:
- A description of the securities sold, including the type and number of shares;
- The date of the sale;
- The adjusted basis of the securities sold;
- The amount received on the sale;
- The name of the ESOP or EWOC; and,
- If the sale was part of a single, prearranged agreement involving other sales of qualified securities, the names, taxpayer identification numbers and the number of shares sold by the other taxpayers.
In addition, the statement of election must be accompanied by the employer’s verified written statement consenting to the application of the early distribution excise tax.Statement of purchase of qualified replacement property. If a seller of qualified securities has bought qualified replacement property by the time of the election, the seller must also attach a notarized statement of purchase to the tax return for the year in which the sale occurs. The statement of purchase must contain:
- A description of the replacement property;
- The cost of the replacement property;
- The date that the replacement property was bought; and,
- A declaration that the property bought is the qualified replacement property.
A seller of qualified securities who does not buy qualified replacement property by the time that his tax return for the year of sale is filed must attach a notarized statement of purchase to his return for the year after the year of the sale of the qualified securities.Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
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