Increasing Capital Gains Rates and Section 1042 Sales

Last week the Wall Street Journal discussed how the expiring tax cuts combined with the proposed health care legislation will result in a 69% Capital Gains Tax Increase:

That surtax takes effect on January 1, 2011, or the day the Bush tax rates of 2001 and 2003 expire. Today's capital gains tax rate of 15% would bounce back to 20% because of the Bush repeal and then to 25.4% with the surtax. That's a 69% increase, overnight. The last time investors were hit with anything comparable was 1986, when the capital gains rate jumped to 28% from 20%, a 40% increase, as part of the Reagan tax reform that lowered income tax rates.

Increases in the capital gains rates will make an IRC Section 1042 Tax Deferred Sale of Stock to an ESOP more attractive. In a Section 1042 sale, if the selling shareholder(s) (1) make the appropriate election, (2) sell enough C Corporation company stock so the ESOP owns at least 30% of the company after the transaction, and (3) invest (a.k.a. rollover) the sale proceeds in qualified replacement property (a.k.a. QRP, generally stocks or bonds of domestic operating companies, though floating rate notes (FRN) can provide additional investment flexibility) within the replacement period (3 months prior to 12 months after), then any gains are deferred until the QRP is liquidated (and then taxed at long-term capital gains rates). If the seller still holds the QRP at death, then the QRP will receive a step-up in basis and taxation will be avoided altogether. This is a powerful business transition and succession planning strategy that will become more valuable as capital gains increase.

Check out a recent post that discussed the IRC Section 1042 rules and a recent Section 1042 Private Letter Ruling or shoot me an email with any questions.

About Employee Stock Ownership Plans (ESOPs)

We are in the process of reviewing the many benefits of ESOPs. We have recently discussed how ESOPs Increase Employee Wealth and Wages and Provide Greater Employment Stability and Increase Job Satisfaction. We will continue to review more of the benefits of ESOPs to employees, business owners, companies, and society in future posts.