Updated Section 1042 Tax Benefits

There is a section of the Internal Revenue Code (IRC) that provides some tax benefits for people who sell their companies to either an ESOP or to a worker cooperative. This blog will explain how 1042 provides tax advantages when selling to a cooperative.  If you are thinking of becoming employee-owned or selling your business to your employees, this is one issue to think about.  What do you do about the potential capital gains tax on the difference between what you invested in the company and what you received for the sale?  As of 2020, the long term capital gains tax can be as high as 20%.  So if you have built your business over a period of years and expect that capital gains might be an issue when selling your business, this blog is for you. 

Code §1042 allows you to sell your stock to a worker cooperative with resulting favorable tax treatment. To qualify for the favorable treatment under §1042, the proceeds from the sale of your interest in the company must be reinvested in a “qualified security,” and the gain then is deferred indefinitely.  In other words, the capital gains that result from the difference between what you invested in the company and what you receive upon sale will not be taxed unless or until you sell the “qualified security” that you purchased from the proceeds of the sale.  And then the gain will be recognized as a long-term capital gain only to the extent that the amount realized on the sale exceeds the cost to the owner of the qualified replacement property (26 U.S.C. 1042(a)(3)). 

 For a very simple example, say you invested $100,000 in your company and over the years it has gained in value.  You sell the company to a worker cooperative for $1,000,000. This creates potential capital gains of $900,000 with possible tax consequences of $180,000.  You use the proceeds of the sale (the $1 million) to purchase a qualified security (like Costco or Target stock). If you sell some or all of the replacement stock in the future, you will then have to pay the capital gains tax. But if you don’t sell it and the Apple stock becomes part of your inheritance, there will be no capital gains tax liability to you or your heirs as there will be a step up in basis upon your death.  

 Specific requirements must be met before §1042 is available to you. To qualify for §1042 treatment, there is a four-step process: 

  1. The sale of the company’s stock must be to an eligible worker-owned cooperative or to an ESOP. 
  2. The selling company must be a C-corporation or an S-corporation for at least three years prior to the sale. An LLC taxed as either an S-corp or a C-corp for the prior 3 years will also qualify for this tax treatment. 
  3. The worker cooperative must own at least 30% of the total value of all outstanding stock, or of each class of outstanding stock, immediately after the sale.  So it does not have to be sold all at once.  A seller can sell 30% of the business to the cooperative in year 1 and then spread the sale of the remaining 70% ownership over a period of time. Please see our blog titled: Selling to a Worker Coop Over Time  
  4. The taxpayer (either you or the cooperative) must file a written statement with the IRS consenting to the application of §§ 4978 and 4979A with respect to the owner or the cooperative. 
  5. Your holding period with respect to the purchased qualified securities must be at least three 3 years (determined as of the time of the sale).  So you have to hold onto the Costco or Target stock for at least 3 years prior to selling.   

In Colorado, the first step is satisfied by the formation of a cooperative under Title 7, either Article 56 or Article 58, of the Colorado statutes.  In other states, check to see if there is either a worker cooperative statute or a cooperative corporation statute that can operate as a worker coop. 

The second step requires some financial planning on your part and the employees who will be purchasing the business. You should first determine the value of the company, which may require the services of a business valuation professional. The employees will be required to find a way to purchase at least 30% of the business the first year of the sale. This may require the employees to obtain a loan or other funding sources for the initial payment. There are other common financing options available, such as an owner carry-back, or the cooperative itself executes a loan to the sellers for the 30% initial payment. The remaining 70% of the purchase price can be paid over a number of years, as determined up front by you and the new employee-owners. 

 The money you receive for the sale of the business must be invested in qualified replacement property for a minimum of three years. “Qualified replacement property” is defined in the Code, but the definition is a little cumbersome. Generally, it means any security issued by an active domestic corporation that is not issued by the company being sold (you can’t invest in another company you own) and that does not have passive investment income in excess of 25% of the gross receipts of the corporation for the preceding tax year. 

Codes §§ 4978 and 4979(a) concern tax on certain dispositions by cooperatives and generally provide that there will be a tax imposed if the cooperative sells the securities it purchased from the owner before the three-year holding period provided in step 4 above is concluded. Of course, a tax professional should be consulted concerning whether a §1042 election is appropriate or even warranted for your particular business. 


As a simplified example of how this might work, suppose that a company has ten employees and you (sole owner) wish to sell the company for an agreed-on value of $750,000. All of the employees wish to purchase the company from you (although it is possible and common to sell the company to fewer than all employees). The employees form a worker cooperative and purchase the entire company. 

 The employees purchase at least 30% ($225,000) in cash on the date of sale and the new cooperative signs promissory notes to you for the remaining 70%. You use the $225,000 to purchase qualified replacement property to be held for at least three years. Because only 30% of the company was purchased the first year, the cooperative is now a 30% owner of the company and the employees are owners of the cooperative, each with one vote and each with the power to participate in the governance of the cooperative. As part of the agreement between you and the new cooperative, it could be provided that you receive certain a Board seat with the cooperative until more of the notes are paid and more of the company has been purchased by the cooperative.  Note that many transactions of this type have an agreement where when at least 50% of the company is purchased by the cooperative, your role as an owner will be at the same level and with the same governance rights as all other employee-owners, or you may decide to retire at this point. 

Over a period of years (all as agreed), either the cooperative itself or the employees can pay for the remaining ownership interests. Payment can be made from net margins or by the employees making additional capital contributions, or by raising capital from non-member outside investors (e.g. through a private placement offering, a crowdfund offering, or a direct public offering). 

Eventually, you are paid in full and can retire, knowing that your company has now been converted to a worker cooperative that will continue into the future, with employee-owners you have trained and who you believe will continue your legacy. The community has not lost a business and its tax base, the employees have job stability and ownership of a business, and their families have the knowledge that a nest egg is growing in the company. When an employee leaves the company or retires, the cooperative can redeem his or her equity account over a period of time or all at once, as agreed by the employee–owners. 

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