The Tax-Free Exit: ESOP & Section 1042 Rollover
The Tax-Free Exit: ESOP & Section 1042 Rollover
Selling to Private Equity triggers a 25% tax bill and destroys your culture. Selling to your employees triggers $0 tax and preserves your legacy. The mechanics of the ultimate “Friendly Buyout.”
Executive Summary
- The Dilemma: You want to sell your $50M business. A Strategic Buyer or PE Firm offers cash, but you will pay ~$12M in taxes (Fed + State) and they will likely fire your loyal staff.
- The Solution (ESOP): You sell the company to an **Employee Stock Ownership Plan (ESOP)**. The company takes out a loan to pay you. The employees get shares for free over time.
- The Tax Magic (Section 1042): If you sell at least 30% of the company to the ESOP and hold the proceeds in “Qualified Replacement Property” (QRP) — basically US stocks or bonds — you pay **$0 Capital Gains Tax**.
👉 The Kicker: If you hold that QRP until death, the deferred tax is **permanently forgiven** (Step-Up in Basis).
The “Floating Rate Note” Monetization
The Liquidity Hack: The law says you must reinvest the sale proceeds into US stocks/bonds (QRP) to defer the tax. But you want cash to buy a boat.
👉 The Strategy:
1. Buy **Floating Rate Notes (FRNs)** (very stable corporate bonds) as your QRP.
2. Pledge these bonds as collateral for a loan (90% LTV).
3. You now have **90% of your exit cash tax-free** in your pocket, while the bonds satisfy the IRS requirement.
Mechanic: The Circular Flow of Cash
Simulation: $20M Business Sale
| Feature | Third-Party Sale (PE/Strategic) | ESOP Sale (Section 1042) |
|---|---|---|
| Tax Treatment | Immediate Capital Gains | Indefinite Deferral |
| Legacy/Culture | Often gutted for efficiency | Protected (Employees own it) |
| Seller Involvement | Exit ASAP (Golden Handcuffs) | Can stay as Chairman/CEO |
“Private Equity buys your past; an ESOP buys your future. The 1042 Rollover is the only vehicle that allows you to sell your cake (get full value), have it (keep the gross proceeds invested), and eat it too (employees keep their jobs).”