It is often the case under the Internal Revenue Code (“Code”) that adherence to procedural rules is crucial to secure tax benefits. Failure to meet these procedural conditions can result in unanticipated tax consequences. In the case of Berman v. Commissioner, 163 TC 1 (July 16, 2024), three taxpayers who failed to comply with the Code Section 1042 provisions that allow for the deferral of capital gains tax in ESOP transactions were saved from being taxed on over $4 million each in capital gains because the court ruled the Code’s installment sales rules under Code Section 453 still applied.
As background, Congress enacted Code Section 1042 to incentivize the adoption of ESOPs. It allows taxpayers to defer, and in certain circumstances eliminate, capital gains tax on eligible stock sold to an ESOP if the proceeds are invested in qualified replacement property. The stock sold to the ESOP must have the greatest voting power and dividend rights. Eligible shareholders, i.e., shareholders who have held the corporation’s stock for at least three years and who sell their stock to the ESOP can invest the proceeds in qualified replacement property within a 15-month period, beginning three months before and ending 12 months after the sale to the ESOP. The ESOP must own at least 30 percent of the company’s stock in aggregate if there is more than one selling stockholder. There are also tax filing requirements, which include a statement of consent, a statement of election, and a statement of purchase.
Qualified replacement property includes common stock with voting and dividend rights; preferred stock; bonds; convertible floating rate notes; and convertible bonds of operating companies incorporated in the United States. Qualified replacement property does not include securities issued by U.S. government entities (so municipal bonds do not qualify); securities issued by non-U.S. entities; domestic subsidiaries of non-U.S. parents; FDIC certificates of deposit; mutual funds; and securities of the corporation that issued the stock sold to the ESOP, and members of that corporation’s controlled group. To constitute qualified replacement property, the entity must be U.S. domiciled with no more than 25 percent of its gross receipts from passive sales, and at least 50 percent of the company’s assets being actively used for business purposes. Capital gains taxes on the sale of stock to the ESOP are not owed until the qualified replacement property is sold, provided certain conditions are satisfied.
Under current law, Code Section 1042 only applies to C corporations. However, under the SECURE 2.0 Act, beginning in 2026, this favorable tax treatment will become available to S corporations but only up to 10% of the value of stock sold to the ESOP. If a corporation converts from an S corporation to a C corporation, Code Section 1042 becomes immediately available to shareholders who have held the corporation’s stock for at least three years.
In the Berman case, the taxpayers had done everything necessary to satisfy the conditions of Code Section 1042. They sold over 30% of their stock to the ESOP in exchange for promissory notes, reported the transaction as a Section 1042 transaction on their tax returns, and purchased qualified replacement property within 12 months using cash and outside loans. However, in the year following the sale, under an aggressive tax strategy applied by some taxpayers at the time, they entered into a purported loan transaction, using 90 percent of their qualified replacement property as collateral for the loan and paying the remaining 10 percent to the lender as a fee. The Tax Court, following the holdings of other courts, determined that the purported loan was actually a sale, a legal conclusion to which taxpayers agreed, and as a result of the sale, Code Section 1042(e) required the recapture of the gain that had been deferred.
Each taxpayer received approximately $449,000 the following year under the promissory notes they received for the sale of the stock, but the IRS sought to tax the entire gain each received from the stock sale – $4,125,00. The IRS’s view was that Code Section 1042 required recognition of the entire gain on the sale rather than taxing the payments under the notes when they are paid under the installment sales rules of Code Section 453. In response, the taxpayers argued that the election to seek 1042 treatment was invalid because the corporation was an S corporation at the time of the sale to the ESOP, or, in the alternative, the election was invalid because of a material mistake of fact or a fraudulent misrepresentation. The Tax Court rejected the argument that the election was invalid under the duty of consistency rule because a taxpayer is precluded from taking a position in a subsequent year that is inconsistent with a position it had taken in a prior year. With respect to invalidating the election, the general rule under the Code is that where a taxpayer can make an election, that election is irrevocable, and the regulations under Code Section 1042 so provided.
As a result of the foregoing, the Tax Court had to reconcile the provisions of Code Section 1042 and the installment sale provisions of Code Section 453. The Tax Court disagreed with the position of the IRS that there was no basis for concluding that an election under Code Section 1042 constituted an affirmative election not to apply the installment method under Code Section 453 because the installment sales rules apply unless a taxpayer affirmatively elects not to be taxed on an installment basis. Thus, the gains that would have been recognized as long-term capital gains in the absence of a Code Section 1042 election would be taxed under the installment sales rules. Accordingly, taxpayers were taxed in the year of recapture under the installment sales method, with an adjustment for basis under Code Section 1042(d). In subsequent years, Code Section 1042 had no effect, and taxpayers could be taxed on the installment basis method.
Our takeaway: In Berman, the taxpayers avoided a disastrous tax result—being taxed on the total phantom income that they, in fact, never received—based on a precise statutory construction of Section 1042. However, the case illustrates that where a taxpayer fails to comply with a statutory provision, the IRS will frequently seek the maximum possible amount of revenue that it can receive.
