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Valuing employer stock in an ESOP

“My client has an employee stock ownership plan (ESOP). How does he value the stock within the plan if it is not traded on a securities market?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Wisconsin is representative of a common inquiry related to valuing stock of the sponsoring employer in qualified retirement plans.

Highlights of the Discussion

For employer securities that are not readily tradable on an established securities market, the IRS requires the shares be valued by an independent appraiser [IRC 401(a)(28)(C)]. Valuation by an independent appraiser is not required in the case of employer securities that are readily tradable on an established securities market.

There are a number of factors to consider when determining the value of an asset within a qualified retirement plan. In its examination guidelines, the IRS supports the use of Revenue Ruling 59-60, which relates to valuing assets for estate tax and gift tax purposes, for valuing assets in qualified retirement plans as well.

In valuing the stock of closely held corporations or the stock of corporations where market quotations are not available, all available financial data, as well as all relevant factors affecting the fair market value must be considered. For example, some factors to consider include the following:

  • Nature and history of the business issuing the security;
  • General economic outlook and the outlook for the specific industry;
  • Book value of the securities and the financial condition of the business;
  • Company’s earning capacity;
  • Company’s dividend paying capacity;
  • Goodwill value; and
  • Recent stock sales.

The list of factors to consider in Rev. Rul. 59–60 is not an exclusive list for valuing closely-held employer securities. It may be necessary to consider other factors when appropriate. Also, not all of the listed factors will be relevant to all companies and transactions. The IRS’ examination guidelines note that the independent appraisal will not, in and of itself, be a good faith determination of value unless all relevant factors are considered.

IRS examiners will look at Form 5500 (Schedule R, line 12) to the question: Does the ESOP hold any stock that is not readily tradable on an established securities market? If the answer is yes, examiners are directed to determine if the securities were valued that year and by whom in order to confirm it was done by an independent, third-party auditor.

Conclusion

An ESOP that holds employer securities that are not readily tradable on an established securities market must follow specific guidelines for annual asset valuation. The valuation requires the use of an independent auditor who observes the requirements of Rev. Rul. 59-60.

 

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ESOP Tax Advantaged 1042 exchange

 

“I have a client who is retiring from a company with an ESOP, and will be selling his shares in his company.  This could subject him to a large tax bill.  Do you have any suggestions on how he might lessen the tax hit?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of discussion

  • Yes, if your client qualifies for a tax-free “1042 Exchange” he can defer capital gains tax on “qualified securities” sold to an ESOP if the proceeds of the sale are reinvested in “qualified replacement property” (QRP) as defined in IRC §1042(c)(4). Stockholders interested in a 1042 Exchange should discuss the option with their attorneys and/or tax advisors before proceeding.
  • Qualified securities for this purpose are employer securities of a C corporation that are either 1)  common stock with voting and dividend rights at least equal to the class of common stock with the greatest dividend rights and the greatest voting rights) or 2) noncallable preferred stock which is convertible into such common stock.
  • QRP includes common stock, preferred stock, bonds, and convertible bonds of operating companies incorporated in the U.S., where 50% of the company’s assets are used in active conduct of a trade or business and no more than 25% of its gross receipts can come from passive sources.
  • The seller will not owe taxes until he later sells the QRP. If the 1042 Exchange is structured properly, the seller could avoid paying all long-term capital gains taxes in certain circumstances. If the selling shareholder dies before liquidating the QRP, thereby leaving the funds as an asset of the estate, the property receives a stepped-up basis and can avoid capital gains all together.
  • Generally, for the sale of stock to qualify for the special tax treatment allowed under IRC 1042, certain criteria must be met.
  • The qualified securities must be sold to an ESOP
  • The selling shareholder must have held the stock for at least three years to qualify
  • Following the sale to the ESOP, the plan must own at least 30% percent of each class of stock or the total value of all outstanding stock of the corporation.
  • The seller must reinvest the proceeds into QRP within 12 months following the sale to the ESOP.
  • Treasury Regulations Section 1.1042-1T  prescribes the requirements of a proper 1042 Election.  The taxpayer must make a written statement of election, attach it to his income tax return, and file on or before the due date (including extensions) for the taxable year in which the sale occurs. The domestic company must consent. Taxpayers who fail to make a timely election cannot subsequently make it on an amended return. And once made, elections are irrevocable.

Conclusion

Properly executed, a 1042 Exchange with an ESOP can be a tax-advantaged way for certain shareholders to sell their stock and delay and, potentially, avoid long-term capital gains tax. Stockholders interested in such a transaction should discuss the option with their attorneys and/or tax advisors.

 

© 2016 Retirement Learning Center, LLC

© Copyright 2019 Retirement Learning Center, all rights reserved