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 Johnson & Johnson’s common stock pass the three tests and count as a Qualified Replacement Property for an ESOP Rollover?
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 Johnson & Johnson’s common stock as a potential 1042 qualified replacement property and 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 Johnson & Johnson's balance sheet from their 2021 Q3 10-Q. The right column is our adjustment removing non-operating assets.
After our adjustment, 92.5% of Johnson & Johnson's assets were involved in the active conduct of trade.
Johnson & Johnson 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, and franchise fees. The standard examples of companies that fail the income test because of too much passive income are Qualcomm with its licensing revenues and McDonald's with its franchise fee revenues.
The only mention of royalty income is this footnote on Other Income from Johnson & Johnson Q3 2021 10-Q.
The table below is Johnson & Johnson's total trailing twelve month revenue.
The amount of royalty income Johnson & Johnson earns is far below the 25% passive income threshold.
Johnson & Johnson passes the income test.
Johnson & Johnson is QRP
Based on our assessment of what constitutes qualified replacement property, Johnson & Johnson appears to pass the three tests to be considered QRP. 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.