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 Visa’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 Visa’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 Visa's balance sheet from their 2021 Q3 10-Q. The right column is our adjustment removing non-operating assets.
Goodwill and Intangibles are considered operating assets because they are non-financial assets. Companies do not earn interest or a return on them and they do not pay interest on them. But we always check the footnotes on Goodwill and Intangibles to see what the company is including in these two line items.
From Visa's 2020 10-K.
Non-financial assets and liabilities. Long-lived assets such as goodwill, indefinite-lived intangible assets, finite-lived intangible assets and property, equipment and technology are considered non-financial assets. The Company does not have any non-financial liabilities measured at fair value on a non-recurring basis. Finite-lived intangible assets primarily consist of customer relationships and trade names, all of which were obtained through acquisitions. 2020 10-K
In our view, Visa's Goodwill and Intangibles are operating assets and we don't need to make an adjustment here.
Visa 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.
Visa earns revenue from the following segments.
The following sets forth the components of our net revenues:
Service revenues consist mainly of revenues earned for services provided in support of client usage of Visa payment services. Current quarter service revenues are primarily assessed using a calculation of current quarter’s pricing applied to the prior quarter’s payments volume. Service revenues also include assessments designed to support ongoing acceptance and volume growth initiatives, which are recognized in the same period the related volumes are transacted.
Data processing revenues are earned for authorization, clearing, settlement, value added services, network access and other maintenance and support services that facilitate transaction and information processing among our clients globally. Data processing revenues are recognized in the same period the related transactions occur or services are performed.
International transaction revenues are earned for cross-border transaction processing and currency conversion activities. Cross-border transactions arise when the country of origin of the issuer, or financial institution originating the transaction, is different from that of the beneficiary. International transaction revenues are recognized in the same period the cross-border transactions occur or services are performed.
Other revenues consist mainly of value added services, license fees for use of the Visa brand or technology, fees for account holder services, certification, licensing and product enhancements, such as extended account holder protection and concierge services. Other revenues are recognized in the same period the related transactions occur or services are performed.
Client incentives consist of incentives provided in contracts with financial institution clients, merchants and strategic partners for various programs designed to grow payments volume, increase Visa product acceptance, win merchant routing transactions over our network and drive innovation. These incentives are primarily accounted for as reductions to revenues.
The table below is the total trailing twelve month revenue for each segment and its percentage of Visa's total revenue. Percentages are based on "Gross Revenue". Client incentives are ignored because the income test focuses on "gross receipts".
The only category that could violate the passive income rule is Visa's "Other Revenue". This category includes revenue from the licensing of Visa's name and brand. But the entire category is 5.1% of Visa's trailing twelve month revenue.
Visa passes the income test.
Visa is QRP
Based on our assessment of what constitutes qualified replacement property, Visa 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.