Using Section 1042 to Reduce Tax Rates During a Cooperative Conversion Sale
The Section 1042 Rollover, part of the Internal Revenue Service (IRS) tax code, can help business owners minimize capital gains taxation when converting their business to a cooperative. Important considerations apply when using the 1042 Rollover during a cooperative conversion.
What is Section 1042?
Section 1042 is part of the IRS tax code. It allows owners of closely-held corporations (corporations with a small number of controlling shareholders) to shelter their capital gains from taxation meaning reduce the amount of taxes you have to pay on the profits you make from selling something valuable like your business. To use the 1042 Rollover, owners must sell at least 30% or more of their stock to their employees and must roll over the sale proceeds into other qualified domestic securities (specific types of investments that meet the requirements set by the IRS for the purpose of a 1042 rollover) within 12 months of the sale.
Historically, business owners have taken advantage of the 1042 Rollover by creating employee stock option plans (ESOPs). But Section 1042 also extends the incentive to owners who sell their business to “eligible worker-owned cooperatives.”
How the 1042 Rollover differs for co-ops and ESOPs
Though the 1042 Rollover applies equally to ESOPs and worker-owned cooperatives, these two options are quite different.
Differentiate between ESOP and co-op:
- Decision-making power: An ESOP is a trust that is managed by a trustee, whereas a worker cooperative is directly owned by the workers. Because an ESOP is only indirectly and partially owned by workers, the cultural shift required to make an ESOP successful is far less dramatic than that required for a worker cooperative.
- Regulations: ESOPs are an employee benefit plan and are regulated by the Employee Retirement Income Security Act of 1974 (ERISA). Worker cooperatives are structural entities and are not regulated by ERISA.
- Organization size: ESOPs require at least 25 employees, but cooperatives have no such minimum.
- Organization goals: The goal with an ESOP is still to maximize shareholder value, whereas the goal of a cooperative is to benefit the members.
- Tax advantages: An employee cooperative is much less expensive to establish and maintain than an ESOP, but it has fewer immediate tax advantages beyond the 1042 Rollover. Additionally, a subchapter T cooperative is not a tax exempt entity, whereas an ESOP is tax-exempt.
Applying the 1042 Rollover
1. If the existing business is a corporation:
Once the initial sale of shares to the cooperative is executed, the selling owners should elect to have their capital gains income from that sale taxed under Section 1042. If the owners reinvest their sale proceeds within one year, taxes on those capital gains will be deferred.
2. If the existing business is a sole proprietorship, partnership, or LLC:
There is precedent for the IRS permitting conversion to a corporation before coopertization in order to take advantage of the 1042 Rollover.
It’s always wise to speak to an attorney and tax professional when navigating this process.
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