Thursday, April 18, 2024
GiftLaw Pro
GiftLaw Note: Some business owners have entered into attractive transactions with an employee stock ownership plan (ESOP). Under this concept, the owner transfers a significant portion of his or her stock to the ESOP. If the donor complies with the required rules as to minimum transfer amount and other qualifications, then he or she may take the proceeds from the sale of personally held company stock to the ESOP and use these proceeds to acquire public securities. The public securities are termed qualified replacement property (QRP) under Sec. 1042 of the Code and gain will be deferred until sale of the stock. Since the owner typically has virtually no basis in the company stock, he or she also has little or no basis in the QRP. Thus, it is attractive to consider the transfer of QRP to a charity. In this ruling, the Service noted that it is possible to transfer QRP to a charity and not cause any recapture of gain. In addition, the holding period of QRP includes the prior holding period of the company stock. Thus, it appears that, immediately after the receipt of QRP, it may be transferred outright to a qualified charity.
This is in response to your letter on behalf of the grantor concerning the application of section 1042 of the Internal Revenue Code of 1986 (Code) to certain transactions described below.

Company A is a corporation organized under the laws of State X. In 1988, Grantor owned 6,842,105 shares (61.55 percent) of the common stock of Company A. In December 1988, Company A established an employee stock ownership plan (ESOP) as defined in section 4975(e)(7) of the Code. The ESOP satisfies the qualification requirements set forth in section 401(a). At the time that the ESOP was established, the Grantor sold 2,257,524 shares of his Company A common stock (20.31 percent of the total outstanding stock) to the ESOP maintained by Company A. Additional shares of Company A common stock were sold to the ESOP at that time so that the ESOP held in excess of 30 percent of the outstanding stock of Company A.

The grantor reinvested his sales proceeds in qualified replacement property (within the meaning of section 1042(c)(4) of the Code), and deferred gain on the sale of the stock under section 1042(a). The basis of the qualified replacement property will be determined under section 1042(d).

The Trust was established by the Grantor on April 15, 1994. The Grantor is the settlor and sole trustee of the Trust. No separate income tax return is filed for the trust, as all tax reporting for the Trust is made on the personal income tax return of the Grantor.

Pursuant to the terms of the trust, the Grantor retains the right to transfer assets to the trust during His lifetime, to direct investment of the trust (both as named trustee and as settlor), to amend or revoke the trust (in whole or in part) and by revocation to transfer the assets of the trust back to himself.

The Grantor proposes to transfer all or a portion of his remaining Company A stock, and all or a portion of his qualified replacement property to the Trust. The Grantor has owned the Company A stock that he proposes to transfer to the Trust for more than three years. When the ESOP is ready to purchase additional shares of Company A stock, the Grantor as trustee will negotiate a sale of the Trust's Company A shares to the ESOP. The proceeds from the sale to the ESOP will be reinvested by the trustee in qualified replacement property.

The Trust, as directed by the Grantor, proposes to donate a portion of its qualified replacement property to various charitable organizations as gifts. All gifts will be made to organizations described in section 170(c)(2) of the Code. Neither the grantor nor the trust will receive money or other property upon the transfer of qualified replacement property to the charitable organizations.

The Grantor has requested the following rulings:
  1. The Grantor may transfer qualified replacement property to the Trust without causing a recapture of gain under section 1042(e) of the Code.
  2. For purposes of section 1042(b)(4) of the Code, the Trust's holding period of the Company A stock includes the period of time the stock was owned by the Grantor prior to his transfer of the Company A stock to the trust.
  3. Provided that the Company A stock constitutes "qualified securities" under section 1042(c)(1) of the Code, the Trust may sell all or a portion of its Company A stock to the ESOP and the Grantor may elect to defer the gain on the sale under section 1042(a) of the Code by the Trust's purchase of qualified replacement property within the applicable replacement period.
  4. A gift of qualified replacement property may be made by the Trust to an organization described in section 170(c)(2) of the Code without causing a recapture of gain previously deferred under section 1042(a) of the Code.
Section 1042(a) of the Code provides that a taxpayer or executor may elect in certain cases not to recognize long-term capital gain on the sale of "qualified securities" to an ESOP (as defined in section 4975(e)(7)) or eligible worker owned cooperative if the taxpayer purchases "qualified replacement property" (as defined in section 1042(c)(4)) within the replacement period of section 1042(c)(3) and the requirements of section 1042(b) and section 1.1042-1T of the Temporary Income Tax Regulations are satisfied.

Section 1042(d) of the Code provides that a taxpayer's basis in qualified replacement property purchased during the replacement period will be reduced by the amount of gain not recognized by reason of the application of section 1042(a). If more than one item of qualified replacement property is purchased, the basis of each item of such property shall be reduced by an amount determined by multiplying the total gain not recognized by reason of the application of section 1042(a) by a fraction: the numerator of which is the cost of such item of qualified replacement property and the denominator of which is the total cost of all items of such property.

Since you have not requested a ruling concerning whether the Grantor has satisfied the requirements of section 1042 of the Code, we express no opinion on this issue. For purposes of your ruling request we will assume that the property purchased by the Grantor is qualified replacement property as defined in section 1042(c)(4) and that section 1042(e) applies to such property.

Section 1042(e)(1) of the Code provides that "if a taxpayer disposes of any qualified replacement property, then, notwithstanding any other provision of this title, gain (if any) shall be recognized to the extent of the gain which was not recognized under subsection (a) by reason of the acquisition by such taxpayer of such qualified replacement property."

The legislative history of section 1042(e) indicates that it was added as part of the Tax Reform Act of 1986 to coordinate the requirement that deferred gain be recognized on the disposition of any qualified replacement property with other nonrecognition provisions of the Code. "Effective for dispositions made after the date of enactment, the Act overrides all other provisions permitting nonrecognition and requires that gain realized upon the disposition of qualified replacement property be recognized at that time." S. Rep. 99-313, 99th Cong., 2nd Sess., 1032 (1986), 1986-3 C.B., v. 3, 1032. Thus, gain realized from the disposition of any qualified replacement property by a taxpayer who made an election under section 1042 must be recognized at the time of the disposition regardless of any other nonrecognition provisions of the Code that may otherwise have applied.

Limited exceptions to this rule are provided in section 1042(e)(3) which provides that the recapture rules of section 1042(e)(1) shall not apply to any transfer of qualified replacement property that occurs: 1) in any reorganization (within the meaning of section 368) unless the person making the election under section 1042(a)(1) owns stock representing control of the acquiring or acquired corporation and such property is substituted basis property in the hands of the transferee; 2) by reason of the death of the person making the election; 3) by gift, or 4) in any transaction to which section 1042(a) applies. Neither the statute nor the Temporary Income Tax Regulations define the term "gift" for purposes of section 1042(e)(3). However, a gift is generally defined as a voluntary transfer of property by one to another without any consideration or compensation.

The proposed disposition of the qualified replacement property to charitable organizations would not result in a gain to the taxpayer. Section 1042(e) of the Code provides that if a taxpayer disposes of qualified replacement, "gain (if any)" shall be recognized to the extent of the gain which was not recognized under subsection (a). The facts of the present case do not indicate that the taxpayer would receive money or other property upon the transfer of the qualified replacement property to the charitable organizations. Thus, no gain would be realized by the taxpayer upon disposition of the property to the charitable organizations. Also, the facts of the present case do not indicate that the transfers of qualified replacement property to charitable organizations would be outside the general definition of a gift. Thus, the transfers of qualified replacement property to charitable organizations would be transfers by gift as that term is used in section 1042(e)(3). Accordingly, the transfer of qualified replacement property to charitable organizations as described above would not cause a recapture of the gain deferred by the taxpayer under section 1042(a) by operation of section 1042(e).

Sections 671 through 677 of the Code contain rules under which the grantor of a trust will be treated as the owner of all or any portion of a trust. Section 676(a) provides that the grantor will be treated as the owner of any portion of a trust if at any time the power to revest in the grantor title to such portion is exercisable by the grantor.

Section 671 provides that, if the grantor is treated as the owner of any portion of a trust, there shall be included in computing the taxable income and credits of the grantor those items of income, deductions, and credits against tax of the trust that are attributable to that portion of the trust to the extent that such items would be taken into account in computing the taxable income or credits of an individual. Under section 1.671-2(c) of the Income Tax Regulations, an item of: income, deduction, or credit included under section 671 in computing the taxable income and credits of the grantor is treated as if received or paid directly to the grantor.

Section 1.671-3(a)(2) of the regulations provides that, if the portion of the trust treated as owned by the grantor consists of specific trust property and its income, all items directly related to that property are attributable to the grantor's portion. Under Rev. Rul. 85-13, 1985-1 C.B. 184, if a grantor is treated as the owner of an entire trust, the grantor is considered to be the owner for federal income tax purposes of all the assets included in the trust.

Therefore, based on the facts presented and representations made, and provided that the Grantor is treated as the owner under section 671 of the Code of the qualified replacement property, assets used to purchase qualified replacement property, and Company A stock sold to the ESOP, we conclude the following:
  1. The Grantor's transfer of qualified replacement property to the Trust will not cause a recapture of gain under section 1042(e) of the Code;
  2. For purposes of Code section 1042(b)(4), the Trust's holding period for the Company A stock includes the period of time the stock was owned by the Grantor prior to his transfer of the Company A stock to the trust;
  3. Provided that the Company A stock constitutes "qualified securities" under section 1042(c)(1) of the Code, the Trust may sell all or a portion of its Company A stock to the ESOP and the Grantor may elect to defer the gain on the sale under section 1042(a) by the Trust's purchase of qualified replacement property within the applicable replacement period, provided that all the requirements of section 1042 and section 1.1042-1T are satisfied;
  4. A gift of qualified replacement property may be made by the Trust to an organization described in section 170(c)(2) of the Code without causing a recapture of gain previously deferred under section 1042(a) of the Code.
Except for the specific rulings provided above, no opinion is expressed concerning the federal tax consequences of the transactions described under any other provision of the Code.

This ruling is directed only to the taxpayers who requested it; section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.

Sincerely yours,
____
James L. Brokaw
Chief, Branch 5
Associate Chief Counsel
(Employee Benefits and Exempt Organizations)

Related Topics On Gift of QRP to Charity

4.6.7  ESOPs and Qualified Replacement Property:    A business owner who has held stock for three or more years may sell the stock to an employee stock ownership plan (ESOP) and acquire qualified replacement property (QRP). The ESOP must hold 30% or more of the stock after the sale. The QRP may include public stocks and bonds in an operating corporation. Sec. 1042(c)(4).



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