When shareholders of a closely held C Corporation sell their shares to an ESOP (Employee Stock Option Plan) and the ESOP owns 30% or more of the common stock the selling shareholders can do an ESOP rollover.
With an ESOP rollover, the selling shareholders can defer their capital gains as long as they invest the proceeds into Qualified Replacement Property (QRP) as defined by section 1042 of the IRS Code. Capital gains on the sale to an ESOP are deferred as long as the QRP isn't sold.
Qualified Replacement Property must pass 3 tests. It must be the right type of security. It must pass an asset test, and then pass an income test.
Does BlackRock’s common stock pass the three tests and count as a Qualified Replacement Property for an ESOP Rollover?
Security Test
1042 Qualified Replacement Property can’t be federal or local government bonds, a mutual fund, an ETF, CD, or a Real Estate Investment Trust.
1042 QRP can be common stock, preferred stock, corporate fixed-rate bonds, corporate convertible bonds, or FRNs.
We’re looking at BlackRock’s common stock as a potential 1042 qualified replacement property so it passes the first test.
Asset Test
To pass the asset test the company must use 50% or more of its assets in "active conduct of trade." The IRS Code doesn't go into further detail.
We'll classify assets into operational or non-operational assets. We'll only count operational assets towards the active conduct of trade.
Operational assets are the assets needed on a daily basis to operate the business. This includes:
- Cash
- Accounts receivable
- Inventory
- Building
- Machinery
- Equipment
- Patents
- Copyrights
- Goodwill
Non-operating assets are assets that can still generate revenue but are not needed for the daily operations of a business. This includes:
- Short-term investments
- Marketable securities
- Vacant land
- Interest income from a fixed deposit
Below is the asset section from BlackRock's balance sheet from their 2021 Q3 10-Q.
The first item to remove and the easiest to identify is the Investment line item.
The next two line items Separate Accounts Assets and Separate Account Collateral Held Under Securities Lending Agreements are harder because they are not readily identifiable as operating or non-operating assets. This is how BlackRock describes each line item.
For Separate Account Assets.
Separate Account Assets and Liabilities. Separate account assets are maintained by BlackRock Life Limited, a wholly owned subsidiary of the Company, which is a registered life insurance company in the United Kingdom (“UK”), and represent segregated assets held for purposes of funding individual and group pension contracts. The life insurance company does not underwrite any insurance contracts that involve any insurance risk transfer from the insured to the life insurance company. The separate account assets primarily include equity securities, debt securities, money market funds and derivatives. The separate account assets are not subject to general claims of the creditors of BlackRock. These separate account assets and the related equal and offsetting liabilities are recorded as separate account assets and separate account liabilities on the condensed consolidated statements of financial condition. 9 The net investment income attributable to separate account assets supporting individual and group pension contracts accrues directly to the contract owner and is not reported on the condensed consolidated statements of income. While BlackRock has no economic interest in these separate account assets and liabilities, BlackRock earns policy administration and management fees associated with these products, which are included in investment advisory, administration fees and securities lending revenue on the condensed consolidated statements of income. [emphasis added]
And for Separate ACcount Collateral Held Under Securities Lending Agreements
In addition, the Company records on its condensed consolidated statements of financial condition the separate account collateral received under BlackRock Life Limited securities lending arrangements as its own asset in addition to an equal and offsetting separate account collateral liability for the obligation to return the collateral. The collateral is not available to creditors of the Company, and the borrowers under the securities lending arrangements have no recourse to the Company’s assets.
When dealing with the IRS and determining if an asset qualifies as 1042 qualified replacement property we will take a conservative approach. Based on the bolded sentences above, we do not think these line items on BlackRock's balance sheet count as assets involved in the active conduct of trade and we will count them as non-operating assets.
The right column is our adjustment removing non-operating assets.
After our adjustments only 30.5% of BlackRock's assets count towards the active conduct of trade.
BlackRock does not pass the Asset Test
BlackRock is not QRP
Based on our assessment of what constitutes qualified replacement property, BlackRock appears to fail the assets test and therefore does not count as 1042 Qualified Replacement property for an ESOP Rollover. However this should not be construed as investment or tax advice, and investors contemplating an ESOP rollover and the investment of 1042 qualified replacement property should first consult with their lawyer and tax advisor.
