How 1042 Transactions Work
A 1042 exchange, also referred to as a “qualified replacement property” (QRP) exchange, is a tax planning strategy available to certain shareholders who wish to defer capital gains tax on eligible stock sold to an employee stock ownership plan (ESOP). Section 1042 of the Internal Revenue Code allows shareholders to reinvest the proceeds from a company stock sale in a QRP without triggering a taxable event.
Securities that qualify for a 1042 transaction include:
- Common stock with voting and dividend rights
- Preferred stock
- Bonds
- Convertible bonds of operating companies incorporated in the United States
In order to be considered a QRP, a company must have the following characteristics:
- Be U.S. domiciled
- Have no more than 25% of gross receipts from passive sources
- At least 50% of the company’s assets must be actively used for business purposes
For a sale to qualify for a 1042 rollover, it must meet the following requirements:
- The seller must have held the shares for at least three years
- The ESOP must own at least 30% of total shares immediately following the sale
- The seller must reinvest the proceeds into QRPs within 12 months following the transaction
What should I use as a QRP?
For many investors, the decision of what to purchase as a QRP comes down to two types of investments: floating rate notes (FRNs) or U.S. large cap equities. At Creative Planning, we typically favor U.S. large cap equities over floating rate notes.
Floating rate notes (FRNs) as QRP
There are several reasons why FRNs are not ideal as a QRP.
- FRNs typically have 30- to 50-year terms, so if you outlive the term, you incur the capital gain (not ideal for younger investors)
- Owning an FRN with a maturing date in an irrevocable trust isn’t beneficial, as the trust will still be subject to capital gains taxes at maturity
- U.S. corporate debt is prone to credit deterioration over long periods of time. FRNs have an exceptionally long term, which means deterioration is likely; this may impact your ability to borrow against your FRNs to build a diversified portfolio
- FRNs lack diversification, as they’re typically heavily concentrated in the financial sector
- Only a limited number of companies issue FRNs, so these investments tend to be highly concentrated in just a few issuers
- A common strategy with FRNs is to purchase them as a QRP then borrow up to 90% to purchase a diversified investment portfolio; one downside to this approach is that the investment portfolio will have carrying costs — in most yield environments, the FRN’s yield is less than the interest incurred on the loan
U.S. Large Cap Equities as a QRP
Buying U.S. large cap equities as a QRP can help you:
- Avoid the large capital gains associated with outliving an FRN (U.S large cap equities are a perpetual investment with no maturity date)
- Achieve diversification across industries
- Avoid a performance lag due to the FRN cost of carry
- You can borrow against your QRP stocks (called margin), if necessary, to add other investments or make withdrawals
It’s important to note that 1042 transactions are complicated financial transactions. The decisions you make can have a significant impact on your tax liabilities and future performance, which is why it’s wise to work with a qualified advisor to ensure your 1042 strategy meets your needs and aligns with your long-term financial goals.
Could you use some help navigating the challenges of a 1042 transaction? Creative Planning is here for you. Our experienced tax advisors work alongside your wealth manager to help ensure your tax planning strategies remain on track. Our teams have experience navigating a wide range of tax and financial challenges, always with a goal of lowering your tax liabilities and helping you achieve your long-term goals.
Schedule a call to learn more.
