The Deferral Is Real. So Is the Structure Underneath It.
Consider an owner selling a company to its ESOP for $100 million with $10 million of basis. That is $90 million of gain. For a California resident, the combined exposure runs to roughly 37 percent — the 20 percent top federal long-term capital gains rate, the 3.8 percent net investment income tax, and California’s 13.3 percent state rate. On $90 million of gain, that is approximately $33 million in tax. Section 1042 allows that seller to defer it.
Congress enacted Section 1042 in the 1980s to encourage owners of closely held businesses to sell at least 30 percent of their company to their employees through an ESOP. It is a legitimate and widely used provision. What gets less attention is what the seller has to do to keep the deferral in place: buy a portfolio of qualified replacement property equal to the sale proceeds, and hold it. When the seller does not receive the full purchase price in cash at closing — which is the norm — building that portfolio usually requires leverage, and that leverage carries a cost that can run for decades.
This post covers the qualification rules, the purchase window, what counts as replacement property, and the leverage mechanics that determine whether the deferral protects a seller’s wealth or slowly erodes it.
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Video Transcript
Chapter 1: The tax deferral that can turn into a lifelong obligation
4 seconds
You just sold your company and someone tells you good news. You don’t have to pay taxes on any of it. Not now. Maybe not ever.12 seconds
Sounds like the best deal in the tax code.14 seconds
But here’s what almost nobody tells you up front.17 seconds
The same strategy that defers your entire tax bill can quietly sell you with a loan you’ll never pay off.24 seconds
Backed by your own personal guarantee.26 seconds
Bleeding cash every single year for the rest of your life. It’s not a scam.31 seconds
Congress enacted section 1042 in the 80s to incentivize the owners of closely held businesses to sell at least 30% to their employees using an Esop.41 seconds
Depending on how it’s built, it either protects the wealth you spent years creating or slowly erodes it without you ever realize it.50 seconds
Today, we’re going to break down section 1042, how the deferral actually works, where the real risk hides, and what questions you need to ask before you sign anything.1 minute
Throughout this episode, we’ll be using an example of a company that sold to their Esop for $100 million.1 minute, 7 seconds
The owners had $10 million in basis, meaning they have $90 million in gain, and they are California residents.1 minute, 16 seconds
Disclaimer we’re not giving financial advice.1 minute, 18 seconds
Always consult with your appropriate advisors.1 minute, 21 seconds
I’m Ben Spadt and along with Trevor Gilmore of Menke this is ESOP Radio. Thanks, man.1 minute, 32 seconds
Yeah.1 minute, 33 seconds
So, Trevor, for someone who spent decades building this company, what’s actually at stake at the moment of sale?1 minute, 39 seconds
The moment we sign on the dotted line, what are the biggest threats to the wealth that they’ve built?1 minute, 44 seconds
So obviously big threat is obviously the value right. The value raise.1 minute, 49 seconds
We’re going to go really now what you come with terms and both sides agree to the price in terms of the insane transaction.1 minute, 56 seconds
The next biggest threat, especially when you think generational wealth and so on is the tax.2 minutes, 1 second
So in this example we have $100 million sale with 10 million a base. So that means we have 90 million of gain.2 minutes, 8 seconds
So 100 minus ten equals 90. Let’s talk a bit about tax rates here.Chapter 2: California math: about 37 percent on a $90 million gain
2 minutes, 13 seconds
And then we’ll dive into the 1042 structures that we see out there.2 minutes, 19 seconds
So if you’re faced with 90 million of gain and you’re a California resident I’m recording here from Newport Beach, California.2 minutes, 27 seconds
So I’m very familiar with California’s state taxes and so on.2 minutes, 32 seconds
Lifetime California resident A lot of our clients are California residents.2 minutes, 36 seconds
So when you think about the combined rates here, the fed is going to be 20%.2 minutes, 42 seconds
That’s your top long term capital gains rate plus 3.8%. That’s a net investment income tax.2 minutes, 48 seconds
And the California state tax on top of that is 13.3.2 minutes, 52 seconds
So when you add it all up, it’s about 37% of that 90 million or 33 million in tax they’re going to pay on this sale.3 minutes, 3 seconds
So a major decision point you have as a seller side to an Esop is do I want to pay the tax or do I want to defer it?3 minutes, 15 seconds
And this is what the tax deferral part.3 minutes, 16 seconds
This is where our conversations lead in today. Yeah.3 minutes, 20 seconds
And so in terms of you know we talk about generational wealth.3 minutes, 24 seconds
And you know, when we’re talking figures this big that certainly, you know falls under that category.3 minutes, 30 seconds
So this individual is concerned with their long term estate plan, including passing down any money to their heirs and perhaps charities of their choice.3 minutes, 39 seconds
You know, that’s when the 1042 tax deferral becomes a critical part of this strategy.Chapter 3: Is Section 1042 the only reason to do an ESOP?
3 minutes, 44 seconds
So I’ve heard rumors and I’ve heard people, you know, a CPA, for instance, and I’m a CPA, so I feel like I can make fun of them.3 minutes, 54 seconds
You as well.3 minutes, 55 seconds
They told me that 1042 is the only reason to do an Esop. I mean, is that true? Not necessarily.4 minutes, 4 seconds
It can be a huge benefit to do one.4 minutes, 6 seconds
But often companies are going Esop for other reasons outside of the tax. Now, yes. You do hear this often. Okay.4 minutes, 13 seconds
Business owners, especially the C Corp’s, are only going to sell if they can do the 1042 or so.4 minutes, 18 seconds
I would say the 1042 is going to be one of the major benefits of a seller going down the seesaw path. If they qualify for 1042.4 minutes, 27 seconds
It’s, it’s a huge benefit.4 minutes, 29 seconds
But each business owner has different facts and circumstances and wealth levels that they have to consider here. So it’s a very nuanced decision.4 minutes, 36 seconds
For those with sizable wealth outside the Esop, the tax deferral may or may not matter, you know, depends on what they have going on.4 minutes, 44 seconds
And the other aspects of their life and their long term estate plan, how they’re passing down money to who it’s going.4 minutes, 52 seconds
Do they have charitable strategies in place?4 minutes, 55 seconds
Are they really concerned of generational wealth, you know, passing money down to heirs and so on?5 minutes
Or are you faced with people that maybe don’t have kids, you know, and, and that becomes an aspect, you know, as well?5 minutes, 10 seconds
Let’s compare and contrast that.5 minutes, 11 seconds
So one business owner has sizable wealth outside the business.5 minutes, 16 seconds
Like maybe this is a second, third, fourth business that they’ve built up and sold. So they already have other strategies. Play here.5 minutes, 24 seconds
Compare that to the business owner who this has been their baby, or maybe it’s second or third generation running the company,5 minutes, 32 seconds
and now they’re so into the Esop, if their wealth is completely tied up in the business, was does make up a lot of 1042.5 minutes, 43 seconds
Transactions out there.5 minutes, 44 seconds
And a lot of you saw transactions as well.5 minutes, 46 seconds
And then the 1042 might be the key to build generational wealth.5 minutes, 53 seconds
Well then you know you, you touch on that. And you’re absolutely right.5 minutes, 58 seconds
A lot of the founders that we talked to, you know, they essentially put all their eggs in one basket, you know, they they love this business.6 minutes, 5 seconds
They loved creating, scaling to get to where they are today.6 minutes, 9 seconds
But now when it’s time to exit, much like, you know, in the in the 40s and 50s, your home was the main source of your wealth.6 minutes, 16 seconds
Now this business is the main source of their wealth.6 minutes, 18 seconds
So let’s talk about the mechanics of making this happen. And, you know, utilizing 1042.6 minutes, 26 seconds
Can you walk me through some basic requirements to to qualify for this election? Yeah, absolutely. Ben.Chapter 4: Qualifying: C corp status, three-year holding, 30 percent threshold Qualified replacement property in plain English
6 minutes, 31 seconds
So 1042 at a high level, it’s simply tax deferral. Think of it like a 1031 exchange.6 minutes, 39 seconds
For those of you out there who have heard of a real estate 1031 exchange very similar in spirit, city owned real estate that’s held for basically income purposes.6 minutes, 49 seconds
You can sell it and then exchange it for lifetime property and not pay the tax your basis carries over the property that you just bought and so on, and you defer the tax.6 minutes, 59 seconds
Similar concept here at 1042. There’s some wrinkles.7 minutes, 3 seconds
So if you’re a business owner you have to be a C corporation to qualify for 1042 tax deferral.7 minutes, 10 seconds
And you must have held the stock for at least three years.7 minutes, 14 seconds
Now, a lot of our clients and a lot of people out there who go down the easy path start off their companies as S Corp7 minutes, 22 seconds
and then convert to see the period that you’ve owned the company as an S corporation, that counts as well.7 minutes, 28 seconds
So if you’re in S Corp and converting to C, then your overall holding period includes that time.7 minutes, 34 seconds
So you need three years holding period of a corporation. You must be a C corp at time of sale.7 minutes, 40 seconds
And collectively the amount of stock sold to the Esop has to be at least 30%.7 minutes, 46 seconds
So it could be one shareholder selling 30% or more.7 minutes, 50 seconds
You know, it could be 100% in that situation.7 minutes, 52 seconds
Or it can be three shareholders selling 10% each.7 minutes, 56 seconds
So that gets you to that 30% threshold as a 30% threshold. That is a key.8 minutes, 1 second
And as a business owner selling the company to the Esop, you will file with your tax return.8 minutes, 9 seconds
So let’s say, it’s 2026 now on your sell in the business.8 minutes, 14 seconds
And you intend to let 1042 and your 2026 tax return, you’re going to include the 1042 election. Same in more on that later.8 minutes, 22 seconds
And your CPA is going to do the do the election and so on, you know, and type up all that. But yeah.8 minutes, 30 seconds
And also well sorry, Trevor, but to interject, you had mentioned something about, you know, finding like kind property or qualified replacement property.8 minutes, 41 seconds
Can you, in the context of a 1042 exchange, explain what that actually means?8 minutes, 47 seconds
What counts and what doesn’t count is as qualified replacement property. Yeah.8 minutes, 52 seconds
So, qualified replacement property at QRP, if you’re going to do a transaction, you’re probably going to hear this.8 minutes, 59 seconds
It’s an acronym. Go to an estate conference. And you know, you heard the cure. Be everywhere as soon as QRP. I’m plain English here.9 minutes, 6 seconds
It’s it’s basically the stocks and bonds that you bought and swapped your private company stock.9 minutes, 12 seconds
So in this example, business owner sold their business to these, for $100 million to do 10429 minutes, 20 seconds
unless it was an S Corp and they took out the basis and so on.9 minutes, 23 seconds
They have to buy a $100 million worth of QRP.9 minutes, 27 seconds
If you take a look at what qualifies as qualified replacement property, I’m going to give a disclaimer here.9 minutes, 32 seconds
Always work with your wealth advisor, financial advisor, and so on.9 minutes, 36 seconds
You know, to make sure that you’re buying qualified. QRP largely it means9 minutes, 44 seconds
the stock of an operating U.S corporation or bonds related to it.9 minutes, 52 seconds
So basically debt.9 minutes, 53 seconds
So basically securities of a U.S corporation that is an operating company.9 minutes, 58 seconds
So passive income, there is a passive income test, largely real estate and REIT’s and so on or passive income.10 minutes, 6 seconds
Those do not qualify.10 minutes, 8 seconds
So if you hear anyone pitching in of a real estate corp, you really want to make sure that it meets the definition of active before you go down that path.Chapter 5: Floating rate notes and public equities as QRP
10 minutes, 19 seconds
And so, what are the most common QRP or qualified replacement property that you see?10 minutes, 26 seconds
One of the most common out there are long dated bonds called friends, floating rate notes and stocks, publicly traded stocks.10 minutes, 35 seconds
Most People’s Corp portfolios include a combination of both friends and stocks.10 minutes, 41 seconds
It’s rare to see a person go all in on one or the other.10 minutes, 45 seconds
It’s working with the advisor to devise these portfolio strategies. You want to think long term.10 minutes, 52 seconds
They’re going to look at your overall wealth level.10 minutes, 54 seconds
Today we’re heading what your goals are, what’s suitable for you, and help you design an appropriate strategy that meets the deferral period of how long you want it to.11 minutes, 5 seconds
For most of these people on Esops, they usually want the deferral period to mean the rest of their life, you know, so you don’t want to make sure you buy securities11 minutes, 14 seconds
that are going to outlive you unless you do.11 minutes, 17 seconds
You don’t want to kick the can down the road 18 months, you know, unless you’re doing, you know, a tax deferral, like a tax,11 minutes, 24 seconds
tax loss harvesting strategy, you know, so on as a way to, over time, get out of that QRP, which that’s beyond the scope of this episode.11 minutes, 35 seconds
So let’s talk a little bit about timing.11 minutes, 38 seconds
What’s the window a seller has to to, you know, identify that property.Chapter 6: The 15-month window to buy replacement property
11 minutes, 44 seconds
You know, invest in that property and and doesn’t matter timing or, you know, kind of walk me through that a little bit.11 minutes, 53 seconds
Yeah.11 minutes, 53 seconds
So you have 15 months to buy your QRP, three months before the transaction closed date12 minutes, 1 second
and 12 months after in practice, most people buy their QRP after the transaction closes, because that’s12 minutes, 9 seconds
when you get like liquidity, the cash to actually go out and buy these replacement securities, buy these stocks and bonds.12 minutes, 16 seconds
There are some situations where you have excess wealth outside of the company, and you can go ahead and start devising a portfolio before the sale,12 minutes, 24 seconds
but that is rare because you want to have the transaction close.12 minutes, 29 seconds
As you always say, in business, it’s not closed till it’s closed right. And you need the liquidity, right?12 minutes, 35 seconds
So, for 99% of business owners out there, it is that 12 months.12 minutes, 40 seconds
But technically the code gives you 15 months.12 minutes, 43 seconds
But even though the ink may not be wet on the the actual transaction, you know, planning probably should take place well ahead of that window, I would presume.12 minutes, 54 seconds
Exactly. Yeah.12 minutes, 55 seconds
So you want to plan the minute you decide to go down this path, your wealth advisor should be looped in.13 minutes, 1 second
If you have a wealth advisor who doesn’t know.13 minutes, 3 seconds
1042, working with your trusted advisors, you should start talking to one, because there’s a lot of key aspects13 minutes, 11 seconds
that go into that transaction planning and also go into planning for 1042.13 minutes, 16 seconds
A big part of that is liquidity or clothes, making sure you have enough bank financing, you know, close or cash close that the company has excess cash13 minutes, 23 seconds
and so on so that you have the liquidity to buy in this portfolio.13 minutes, 28 seconds
And yes, there’s leverage involved in a lot of these so that you can leverage up.13 minutes, 33 seconds
But about still, at the end of the day, you’re going to need a sizable amount of liquidity.13 minutes, 37 seconds
And you want to make sure that the whole transaction is designed with that in mind.13 minutes, 43 seconds
That’s exactly what I wanted to talk about next is, you know, in, let’s say, the vast majority of these Esop transactions,Chapter 7: Seller notes and the liquidity gap
13 minutes, 51 seconds
I, as the seller, don’t walk away with 100% cash or close.13 minutes, 56 seconds
I’ll have a seller note for a portion or perhaps all of it.14 minutes
How does that complicate things if I need.14 minutes, 3 seconds
You know, if I sell for 100 million and I need 100 million in qualified replacement property, how can I make that math work? Yeah.14 minutes, 11 seconds
So let’s give a hypothetical scenario here.14 minutes, 13 seconds
So then you start the business to these are for 100 million.14 minutes, 17 seconds
Let’s say you took out a bank loan for 25 million.14 minutes, 20 seconds
The company took out a bank loan, I should say, for 25 million.14 minutes, 23 seconds
And then you’re carrying 75 million in seller notes, and you intend to go down the 1042 path?14 minutes, 29 seconds
Sell transaction closes. You have 25 million in your pocket.14 minutes, 36 seconds
The 75 million is going to be paid to you over time.14 minutes, 39 seconds
So in terms of long term cash flows and really viewing that as a long term annuity, you know, so you’re selling I is going to pay you interest rate.14 minutes, 48 seconds
It’s going to pay the principal.14 minutes, 49 seconds
Maybe the business over time will refinance your seller notes and, you know, cash you out over time. That’s definitely a strategy.14 minutes, 56 seconds
But let’s for simplicity’s sake, let’s say you only have 25 million to get this $100 million portfolio. How are you going to do that?Chapter 8: Using leverage to reach a full QRP portfolio
15 minutes, 5 seconds
Well, the answer is leverage.15 minutes, 6 seconds
So working with your wealth advisor who’s going to go out and, find appropriate securities?15 minutes, 14 seconds
I’ll give you a very simple example.15 minutes, 16 seconds
Let’s say they decided, hey, Ben, floating rate notes are the way to go. That’s, for this tax deferral.15 minutes, 23 seconds
1042 and your scenario, let’s do a long dated floating rate notes.15 minutes, 28 seconds
So they’re going to go out and find that are of sufficient quality, longevity. So ideally these outlive you, Ben.15 minutes, 38 seconds
And that they’re going to obviously powered interest. So let’s talk about the leverage piece.15 minutes, 44 seconds
So you assemble portfolio friends.15 minutes, 48 seconds
And these can be you know, let’s say it’s issued by I’ll just throw out names or AT&T or what have you, you know, these15 minutes, 55 seconds
well known high quality issuers, the bond itself in terms of investment, you know, it’s it’s not really it’s not like an equity.16 minutes, 4 seconds
You know, you’re not going to get a lot of capital appreciation and so on. Over time. But it will pay off interest.16 minutes, 11 seconds
The beauty about friends is that they can be leveraged and very high, highly leveraged.16 minutes, 17 seconds
So you need to buy a hundred million of friends. You have 25 million of cash.16 minutes, 23 seconds
The bank that you’re working with, get these friends.16 minutes, 26 seconds
They’re going to devise a strategy that you’re going to buy $100 million worth of friends using leverage so their friends can be leverage up to 85, 90%.Chapter 9: Negative carry and stress testing the margin cost
16 minutes, 37 seconds
So the fact of 25 million, you’re off to a good start.16 minutes, 40 seconds
You can start buying these friends and use leverage and assemble a $400 million foreign portfolio.16 minutes, 49 seconds
Okay, now let me just get this straight.16 minutes, 51 seconds
So the with those bonds, those floating rate notes, I’m it’s kicking me off some percentage of interest every year.16 minutes, 59 seconds
But then that margin is going to cost me some interest every year.17 minutes, 4 seconds
Am I still coming out ahead or what happens in that situation?17 minutes, 9 seconds
It depends on the difference between the interest rate that the bond pays. Yeah. And the cost of the leverage. So the leverage flow.17 minutes, 17 seconds
So you can run into a situation of what’s called negative carry.17 minutes, 20 seconds
Meaning you’re on the hook for that delta between the two.17 minutes, 24 seconds
If the margin expense is higher than the interest income you receive from the bond.17 minutes, 31 seconds
And that can that’s going to happen in perpetuity, you know, tells something, changes interest rates, you know, so on to to flip it back.17 minutes, 38 seconds
And so that’s definitely something that your advisor is going to model out and show you scenarios.17 minutes, 44 seconds
We recommend stress testing testing these out in a higher interest rate environment, testing them out.17 minutes, 50 seconds
If rates don’t change over the next 3040 years, which, you know, it’s never been the case, maybe rates go down.Chapter 10: What a leveraged portfolio does to an estate
17 minutes, 56 seconds
So be able to stress test and understand what that true cost is to you and how much you’re on the hook for if you’re going down this leveraged path.18 minutes, 6 seconds
Yeah, that’s you know, that that opens up a whole new host of questions.18 minutes, 11 seconds
So, you know, we’re talking about these friends outliving me.18 minutes, 14 seconds
I would presume then that my margin to to buy these friends is also going to outlive me.18 minutes, 21 seconds
So what impact could that have on my estate if I am paying more interest that I am receiving was definitely going to erode your value of the estate.18 minutes, 30 seconds
But let’s think this through.18 minutes, 31 seconds
So you also care to SA okay, so you’re going to get interest income and principal paid on on that $75 million.18 minutes, 38 seconds
And then the next question is what did you do with that money.18 minutes, 41 seconds
So if you use it to actually deleverage from the friends then your estate, all things equal, you know, it’s18 minutes, 49 seconds
it’s going to be protected if you spend it on lifestyle expenses, invested in a much startups that didn’t go anywhere,18 minutes, 57 seconds
you know, so on, you know, you basically wasted money from your estate, right?19 minutes, 1 second
And, possibly the only thing left is these friends, as it really depends on what you did with that extra liquidity because you leveraged for a reason.19 minutes, 12 seconds
And the reason is you didn’t have the cash to buy the for, friends, or it was a smart move.19 minutes, 18 seconds
And then as you got your seller notes and either do you leveraged or you use it to invest in other investments that19 minutes, 26 seconds
kick off a higher rate of return, you know, so maybe as real estate around the world. Right.19 minutes, 30 seconds
And maybe by the time you pass and, and these homes and these friends become part of your estate,19 minutes, 39 seconds
the real estate value and so on, you know, has gone up 2 or 3 acts, you know, whatever the case is. Right?19 minutes, 43 seconds
So, the biggest question is what did you do with that?19 minutes, 47 seconds
You know, then that’s kind of the be the answer to what it means for your heirs.19 minutes, 52 seconds
An extreme downside, like let’s say you kept it fully leveraged and use that cash on, you know, lifestyle expenses. You bought a jet.20 minutes
You know, those are notoriously expensive to operate, you know, and they go down in value. Right?20 minutes, 5 seconds
So you bought that, you fueled, you know, you know, extremely expensive lifestyle, you know, and so on.20 minutes, 13 seconds
Well, if the only thing the air is good is, lovers ever own portfolio, then whatever that net value is, that’s that’s what they got, you know, from the estate.20 minutes, 24 seconds
Because the leverage will still stick.20 minutes, 25 seconds
You know, it’s still a leverage portfolio.20 minutes, 27 seconds
So they then will probably, you know, sell the friend, unwind it, and, you know, use the, the estate,20 minutes, 34 seconds
you know, will then use that, that cash to distribute.20 minutes, 38 seconds
If I play my cards right and I do delever over time, you know, maybe I do have a few expenses that,20 minutes, 46 seconds
you know, are solely, you know, a little bit of my own personal taste, but, you know, then20 minutes, 56 seconds
I’m essentially kicking the can down and all the way down the road, and it’s a permanent tax deferral at that point with, hopefully just a minimal margin cost.21 minutes, 7 seconds
So, yeah, let’s give a scenario here with that 75 million. Yeah. You reinvested.21 minutes, 12 seconds
You did, you know, smart portfolio equities.21 minutes, 16 seconds
Maybe you invested in some private companies. You know, real estate, you name it. Right.21 minutes, 21 seconds
So you had a basically a diversified portfolio, but you kept these up.21 minutes, 25 seconds
And so, you pass the day to death with the value of all those assets,21 minutes, 32 seconds
then become part of the estate, you know, and, I won’t get into estate valuation. That’s a whole other topic.21 minutes, 38 seconds
But, you know, the value of that becomes part of the estate.21 minutes, 41 seconds
So if you use the leverage smart, you know, the long term and got higher return outside of21 minutes, 50 seconds
that, you know, that bet, that beat the the leverage expense here, you know, then the heirs are going to be that much better off, you know, maybe21 minutes, 57 seconds
2 to 300 million in your estate versus the 100 million. True, true.22 minutes, 4 seconds
Now, you had mentioned that not only could I invest in these friends, but also equities.22 minutes, 10 seconds
So let’s say I do have those AT&T friends.22 minutes, 14 seconds
But maybe I want to AT&T stock can you talk me through how I can use them diversified equities22 minutes, 22 seconds
QRP and said, yeah, there’s strategies out there that, on the equity side, there’s, you know,22 minutes, 30 seconds
some strategies out there that involve using leverage and so on.22 minutes, 35 seconds
The big picture, most people are going to do a strategy that includes both equities and friends is very rare. That is one or the other.22 minutes, 43 seconds
But you do have some people who love equities hate the idea bonds, you know, vice versa. Right.22 minutes, 48 seconds
So but yeah, let’s say you go through with like a 5050 equity position. So you’re buying 50% equities.22 minutes, 54 seconds
Your advisor gives a list of 1040 to eligible securities a buy and you buy them, you know, fortune 500 companies, you know, etc..23 minutes, 3 seconds
And let’s say you hold it over ten years.23 minutes, 4 seconds
So you hold that portfolio ten years and then same thing.23 minutes, 8 seconds
You hold that, friend for ten years, so that so that your ten, you know, the measurement is going to be what has been the return during that time.23 minutes, 16 seconds
Usually equities beat bonds.23 minutes, 19 seconds
So you know you look at the history of the S&P the overall stock market for instance Amazon you know if you bought it back at issuance.23 minutes, 27 seconds
And now in the middle of 2026 it’s got upward 900 plus percent. Right.23 minutes, 32 seconds
So usually equities are going to win in terms of overall appreciation.23 minutes, 40 seconds
Because the bond itself it’s not you know it’s not going to appreciate you got an interest in them and so on.23 minutes, 47 seconds
But and depending on the credit quality and so on, the value that can move around interest rates, value, it moves around.23 minutes, 55 seconds
So usually long round equities, just like the fact that you own this business that went from 10 million24 minutes, 3 seconds
worth your initial basis, up to 100 million. Same thing with public company equities. Usually you’re going to see that.24 minutes, 10 seconds
So people seeking that, you know, are going to do a mixed portfolio.24 minutes, 17 seconds
They are not just going to go all in on, friends or equities for that matter. You know, a balance risk right.24 minutes, 25 seconds
And balancing risk is important.24 minutes, 29 seconds
So is that, you know, the primary driver, or I guess the primary trade off here24 minutes, 35 seconds
is that, you know, the risk, of an equity versus the risk of, of a bond from a company.24 minutes, 43 seconds
Right.24 minutes, 43 seconds
So the beauty of the bonds is they’re long dated.24 minutes, 47 seconds
You can find friends out there that are 30 plus years.24 minutes, 50 seconds
So, you know, it’s designed, depending on your age, to outlive you or get very close.24 minutes, 58 seconds
Equities, you’re going to want it to stay in existence, you know, but if you stand 1042 equities for a long time,25 minutes, 6 seconds
there’s so many mergers acquisitions out there are companies going to take them private, you know.Chapter 11: What ends the deferral, and tax-loss harvesting
25 minutes, 10 seconds
So on sell if you sell that security then the tax deferral ends at that point.25 minutes, 16 seconds
So you do see over time advisors doing what’s called25 minutes, 23 seconds
tax loss harvesting and other strategies to basically offset the gains and basically get you out of that friend position either whole or part over the long term.25 minutes, 34 seconds
So it would be very rare for someone to actually hold a friend just indefinitely, you know, forever. It’s out there for sure.25 minutes, 39 seconds
But, the modern strategies out there often involve some sort of de leverage out of the friend.25 minutes, 46 seconds
And so when you’re talking about tax loss harvesting, I’m selling this equity that, has been, part of my 1042 exchange.25 minutes, 56 seconds
And I got this dog somewhere else in my portfolio that’s lost money on.26 minutes
And if I sell that and sell my 1042 stock, hopefully I can at least, you know, minimize my, capital gains there, if not totally eliminated.26 minutes, 10 seconds
Is that what you’re saying? That’s right. Yeah. So, yeah.26 minutes, 13 seconds
So capital gain over here and then you have a capital loss over here. So you’re going to ideally match those.26 minutes, 21 seconds
Doesn’t always work out. Perfect dollar for dollar. Of course not. Right.26 minutes, 24 seconds
But you’re you’re matching it as best you can. Right.26 minutes, 28 seconds
And you know we’re we’re talking a lot about succession here a lot about legacy.26 minutes, 33 seconds
And you know a good number of people we talked to this is a multi-generational business a multi-generational decision.Chapter 12: Questions to ask advisors before signing
26 minutes, 41 seconds
So if you were advising a family member through this, what questions would you tell them to ask their advisor before they sign anything?26 minutes, 51 seconds
Absolutely.26 minutes, 52 seconds
So a big part of this then ties into your overall long term trust estate and wealth preservation strategy.27 minutes
So it all needs to be tied together.27 minutes, 2 seconds
So this and 42, especially if the business is a large portion of your wealth, this needs to be front and center.27 minutes, 9 seconds
So making sure your trust attorney is you have on I’m assuming someone at this wealth level does is tied in wealth advisor27 minutes, 18 seconds
is tied in often they work with certain banks.27 minutes, 22 seconds
All the major banks out there have some sort of Esop 1042 team.27 minutes, 27 seconds
You know, the JP morgan’s of the world, you know, and so on right there, all of them do.27 minutes, 31 seconds
And making sure that it’s a collaborative team, a cohesive team with one vision.27 minutes, 37 seconds
And that vision really starts with the family, right?27 minutes, 39 seconds
So you as a controlling shareholder, what is your strategy in crafting that.27 minutes, 43 seconds
And that’s going to make this whole thing go through orderly and make sure that one, two, three years in,27 minutes, 52 seconds
you’re going to be happy with the strategy.27 minutes, 53 seconds
Because once you’re in a 1042 strategy, you’re in it.27 minutes, 56 seconds
You can’t sell equities, go in and out of equities.27 minutes, 59 seconds
I mean, once you sell it, boom, the 1042 ends at that point.28 minutes, 2 seconds
And you pay you pay the piper at that point.28 minutes, 5 seconds
So making sure that it’s part of that cohesive strategy, that’s that’s the key. So as we always say plan early.28 minutes, 13 seconds
You plan often and educate yourself as well.28 minutes, 16 seconds
So education is such a key component here, you know, to business owners who’ve gone down these high path and they’ve28 minutes, 24 seconds
got 1042 portfolios and they didn’t even know what they bought.28 minutes, 28 seconds
They just know my advisor told me to do what I did, you know, so on.28 minutes, 31 seconds
And it’s it’s a it’s, you know, that’s alarming to hear that. Absolutely.28 minutes, 37 seconds
Especially, you know, if you do need to draw on that investment for your lifestyle or, you know, for if you had planned charitable giving that.28 minutes, 46 seconds
Oh, well, my money’s all tied up in these 1042 friends.28 minutes, 51 seconds
You know, I that’s where that that early and often planning is important, you know.28 minutes, 57 seconds
And the answer is it’s going to be different for every single business owner.29 minutes, 1 second
I think, you know, when you’re faced with that, that decision. Absolutely.29 minutes, 6 seconds
And also one thing to ask to is, you know, is this a legitimate strategy?29 minutes, 11 seconds
There’s 1042 strategies out there that aren’t provided by large institutions that might be novel and so on, and rely29 minutes, 20 seconds
on some sort of tax opinion, not necessarily a private letter rolling in, which is the the gold standard. There.29 minutes, 25 seconds
So make sure you understand clearly what you’re buying and also what you’re signing and what the fees are both now and in the future. I mean, that’s crucial.29 minutes, 33 seconds
Friends generally are very cheap to transact and typically don’t carry long term advisory fees associated with them.29 minutes, 41 seconds
Equities.29 minutes, 42 seconds
Some other strategies out there do you know.29 minutes, 44 seconds
So just understand what the big picture cast is for today and long term.29 minutes, 51 seconds
And also fully understand the tax ramifications if you need to tap that foreign portfolio for liquid in future, sell29 minutes, 59 seconds
some what that means and also understand truly the cost of the leverage. So. 1042 so beautiful part of the tax code.30 minutes, 7 seconds
It’s in there for a reason.30 minutes, 8 seconds
Congress enacted it back in the 80s to broaden Esop ownership, making that exit to an Esop more appealing by having the send there.30 minutes, 18 seconds
There’s other awesome parts of the tax code qualified small business like USPS.30 minutes, 22 seconds
We’re going to talk about that in a different episode. You know that’s in there as well too.30 minutes, 27 seconds
I incentivize people to start startups, you know, and then you have some deferral that you can do with that, you know, to reward people for taking that risk.30 minutes, 36 seconds
So, you know, it’s it’s a legit part of the tax code.30 minutes, 40 seconds
And a lot of people have avail themselves of it.30 minutes, 44 seconds
And, you know, it’s like anything you have to understand the pros, cons, advantages, pitfalls so that you deviseChapter 13: The biggest QRP mistake and outliving your notes
30 minutes, 51 seconds
the right strategy that’s going to endure because you want it to endure.30 minutes, 55 seconds
You know, it needs to be part of a cohesive, long term wealth plan and long term estate plan.31 minutes, 2 seconds
Absolutely, absolutely.31 minutes, 4 seconds
Now, you know, we’ve talked a lot about perfect planning.31 minutes, 8 seconds
What’s the biggest mistake you’ve seen a seller run into with their QRP strategy, and how could it have been avoided?31 minutes, 16 seconds
I would say not understanding what exactly they were buying, you know. So that’s probably the biggest one.31 minutes, 22 seconds
I mean, me and my spouse are bought securities in the past that we didn’t fully understand.31 minutes, 28 seconds
Some of them are in the qualified opportunity zone and so on. You know, a hindsight’s always 2020. You go back and like, oh, okay.31 minutes, 36 seconds
You know, I’m learning lesson. So I would say avoid that. Make sure you truly understand.31 minutes, 43 seconds
There’s a lot of acronyms thrown out there in the 1042 world, a lot of varying opinions.31 minutes, 50 seconds
But just make sure you understand big picture what exactly it is that you’re getting yourself into and understand.31 minutes, 59 seconds
I always like to ask the question, how can this whole thing blow up? You know?32 minutes, 3 seconds
And that’s because you always commands upside. Upside is awesome.32 minutes, 6 seconds
You know, you know, we always want to understand the downside. How can this whole thing blow up.32 minutes, 11 seconds
And that’s and the opportunities are, as I mentioned earlier, a lot of those.32 minutes, 14 seconds
The value went to zero in those, you know, not saying totally out is this is an apples to apples.32 minutes, 19 seconds
So we’re not talking about opportunity zones at all right now. We’re talking about 1042.32 minutes, 23 seconds
I’m just saying you need to understand, you know, clearly what the downside is because generally the upside takes care of itself.32 minutes, 30 seconds
And also there’s stories out there as well where the seller outlives the floating rate. Note that they bought, sell.32 minutes, 38 seconds
And we’re seeing a trend here to sellers. Are younger and younger.32 minutes, 43 seconds
You know, we do deals all day long with founders who are in their late 40s, 50s, and they go down the 1042 path.32 minutes, 50 seconds
Well, it’s a real lift 100, which a lot of people do these days.32 minutes, 55 seconds
You know, that you’re probably going to outlive the friend.32 minutes, 58 seconds
So that means at some point in your life, unless you totally do love it out of it, using tax loss harvesting or whatever strategy33 minutes, 5 seconds
you’re going to find, a morning that you wake up and you basically have outlived it, you know?33 minutes, 12 seconds
So then that means, pretty large capital gains. Bullpen can become, do at that point.33 minutes, 17 seconds
So planning around that, you know, and so on, and also foreign quality, making sure that it’s top quality that,33 minutes, 26 seconds
of course, no one has a crystal ball, so you can’t predict the future precisely, you know, ten, 15 years in the future33 minutes, 35 seconds
with the quality that’s going to be generally, you’re going to want to find the highest quality friend because you don’t want to be faced with excess margin calls33 minutes, 43 seconds
or any sort of possibility that the deferral blows up in some way.33 minutes, 47 seconds
You know, that’s because all all that’s out of your control, what is in your control is understanding what you’re getting into and making the most sound decision you can at that moment.33 minutes, 57 seconds
All right.33 minutes, 58 seconds
Well, thank you, Trevor, for, walking us through that. That, was very insightful. Thanks, Ben.34 minutes, 5 seconds
And thanks, everyone for joining us today. I hope you learned something new. Feel free to reach out to us.34 minutes, 10 seconds
I’m Trevor Gilmore on LinkedIn, Ben Spadt on LinkedIn as well.34 minutes, 14 seconds
Check out our website, Menke.com and stay tuned for future episodes.34 minutes, 18 seconds
We have one coming up on QSBS qualified small business stock, how that interplays with Esops and more. Have an awesome day everyone!34 minutes, 26 seconds
Thanks. Goodbye.What It Takes to Qualify
Three requirements sit at the front of every 1042 analysis.
C corporation status at the time of sale. The election is not available to S corporation sellers. Many companies that pursue an ESOP start as S corporations and convert.
A three-year holding period. The seller must have held the stock for at least three years. Time held while the company was an S corporation counts toward that period, so a conversion shortly before a transaction does not reset the clock.
At least 30 percent sold to the ESOP. The threshold is measured collectively, not per seller. One shareholder selling 30 percent qualifies. So do three shareholders selling 10 percent each. A 100 percent sale obviously clears it.
The election itself is filed with the seller’s tax return for the year of the sale, prepared by the seller’s CPA.
Qualified Replacement Property, in Plain English
Qualified replacement property — QRP — is the portfolio the seller buys with the sale proceeds. In practical terms it means securities of an operating U.S. corporation: stocks or corporate debt. There is a passive income test, and assets such as real estate holdings and REITs generally fail it. If someone presents a real estate entity as QRP, it is worth confirming carefully that it meets the active business definition before proceeding.
The two most common holdings are long-dated floating rate notes and publicly traded equities. Most portfolios contain both. Going entirely into one or the other is unusual, and the mix should be built with a wealth advisor around the seller’s age, goals, and intended deferral period. For most ESOP sellers, that intended period is the rest of their life, which argues for securities that outlive them.
The 15-Month Window
The code allows 15 months to purchase QRP: three months before the closing date and twelve months after. In practice, close to all of it happens after closing, because that is when the liquidity exists. Planning, however, should start much earlier — the moment the seller decides to pursue this path. A wealth advisor who does not know Section 1042 is a problem worth solving before the transaction is designed, not after.
Seller Notes, Liquidity, and Leverage
Here is where the structure gets demanding. Take the $100 million transaction above. Suppose the company borrows $25 million from a bank to fund cash at closing, and the seller carries $75 million in seller notes. The seller has $25 million in hand. The QRP requirement is still $100 million.
Leverage fills that gap. Floating rate notes from high-quality issuers can be borrowed against heavily — up to roughly 85 to 90 percent — so $25 million of cash can support a substantially larger note portfolio. The math works. The question is what it costs.
Negative Carry
The bonds pay interest. The margin loan charges interest. If the cost of the leverage exceeds the interest income from the bonds, the seller covers the difference — and does so every year, indefinitely, unless something changes. That is negative carry. Any advisor proposing a leveraged QRP strategy should model it out and stress test it: a higher rate environment, a flat rate environment held for thirty or forty years, a declining rate environment. The seller needs to see what they are on the hook for before closing, not after.
What It Means for an Estate
A leveraged portfolio that outlives the seller passes to heirs with the leverage attached. Whether that is a good outcome depends almost entirely on what the seller did with the seller-note payments as they arrived. Payments used to deleverage the portfolio preserve estate value. Payments reinvested into assets that outperform the cost of the leverage can grow it. Payments spent on lifestyle leave heirs with whatever net value remains after the borrowing is unwound.
Ending the Deferral, on Purpose or by Accident
Selling QRP ends the deferral on what was sold, and the gain becomes taxable at that point. This is why the portfolio cannot be traded like an ordinary account. It also explains why advisors often pair 1042 positions with tax-loss harvesting elsewhere in a client’s portfolio — matching realized losses against 1042 gains to deleverage gradually over time rather than facing the full liability at once.
There is a related timing issue that is becoming more common. Sellers are getting younger. Founders in their late 40s and 50s now regularly go down the 1042 path, and a 30-year note bought at 50 may not outlive an owner who reaches 90. At some point the note matures, the deferral ends, and a significant capital gains bill arrives. That scenario should be planned for at the outset, not discovered later.
Questions Worth Asking Before You Sign
The most common mistake is not a technical one. It is sellers who hold 1042 portfolios and cannot say what they own or why. A few questions prevent that:
- Is this a well-established strategy, or a novel one relying on a tax opinion rather than a private letter ruling?
- What are the fees, now and over the life of the position? Floating rate notes are generally inexpensive to transact and typically carry no long-term advisory fee. Other strategies do.
- What is the true cost of the leverage under several rate scenarios?
- What happens if I need to tap this portfolio for liquidity, lifestyle, or charitable giving?
- How can this blow up?
That last one matters most. Upside tends to take care of itself. The downside is what needs to be understood in advance.
Looking Ahead
Section 1042 is a durable, legitimate part of the tax code, and for many owners it is one of the strongest reasons to consider an ESOP. It is not, however, a standalone decision. It has to sit inside a coherent plan that includes the trust attorney, the wealth advisor, the CPA, and the family’s own view of what the money is for. Plan early, plan often, and make sure the people advising you are working from the same picture. Once you are in a 1042 strategy, you are in it.
If you are weighing an ESOP as an exit and want to understand how the tax and financing pieces would work for your company, our Feasibility Questionnaire produces a free preliminary analysis.
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About ESOP Radio
ESOP Radio is the official ESOP podcast from Menke — where real stories of growth, succession, and long-term wealth building are told.
Hosted by Trevor Gilmore and Ben Spadt, the show features conversations and educational episodes designed to help business owners better understand employee ownership.
Disclaimer
This podcast is provided for educational purposes only and does not constitute legal, tax, investment, or fiduciary advice.
Phil DeDominicis is an ESOP strategist and M&A advisor who has guided 300+ companies through ESOP formations, financing, and transactions over 20+ years at Menke & Associates. He specializes in selling ESOP‑owned businesses to financial or strategic buyers and in helping ESOP companies acquire other businesses.
