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 Starbucks’ 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 Starbucks’ 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 Starbucks' balance sheet in their most recent SEC filing, the 2021 10-K.
Starbucks's balance sheet is straight forward unlike what we saw with Blackrock. We have two line items to remove as non-operating assets, Short-term Investments & Equity Investments.
After we remove those two line items the remaining 98.6% of Starbucks' assets are used in the active conduct of trade.
Starbucks passes the Asset Test.
Income 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 Starbucks Income Statement from its 2021 10-K.
Right away we see that it has licensing revenue with its licensed stores. Starbucks also earns royalty income that is listed under the Other Revenue line item.
Other revenues primarily are recorded in our Channel Development segment and include sales of packaged coffee, tea and ready-to-drink beverages to customers outside of our company-operated and licensed stores, as well as royalties received from Nestlé under the Global Coffee Alliance and other collaborative partnerships. - 2021 10-K
Even if we count all Other Revenue as passive income and combine it with revenue from Licensed Stores, it only accounts for 18% of Starbucks' total revenue.
Starbucks passes the income test.
Starbucks is QRP
Based on our assessment of what constitutes qualified replacement property, Starbucks 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.
