What is 1042 Qualified Replacement Property
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.
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 interested in Broadridge Financial’s common stock as a potential 1042 qualified replacement property so it passes the first 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:
- Accounts receivable
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 Broadridge Financial's balance sheet in their most recent SEC filing, 2022 Q2 10-Q.
I made two adjustments to Broadridge's balance sheet. In the notes section, we see that we have to remove $0.7 million from Other Current Assets and $132.9 million from Other Non-Current Assets.
After those two adjustments, Broadridge still has 98.4% of its total assets involved in the "active conduct of trade".
Broadridge Financial passes the Asset Test.
To count as Qualified Replacement Property a company's passive income "cannot exceed 25% of its gross receipts in the year preceding its purchase."
Passive income is royalty income, licensing income, franchise fees, and rent from real estate. The two most common examples of companies that don't pass the income test are Qualcomm with their licensing revenue and McDonald's with their franchise revenue.
Below is the trailing twelve months of revenue for Broadridge Financial.
Broadridge Financial does not have passive income and therefore passes the Income Test.
Broadridge Financial is QRP
Based on our assessment of what constitutes qualified replacement property, Broadridge Financial appears to pass the security test, the asset, test, and the income test and therefore counts 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.