Replacement Property Disposition after ESOP Sale Results in Recognition of Deferred Gain.

Taxpayer T is a shareholder of Company A, a closely held domestic C corporation. A maintains an employee stock ownership plan (ESOP) that satisfies the requirements of Sec. 4975(e)(7). A has one class of common stock that constitutes employer securities under Sec. 409(1). T did not receive the shares in a distribution from a plan described in Sec. 401(a), or a transfer pursuant to an option or other right to acquire stock to which Sec. 83,422 or 423 applied. T sells all of the A shares to the A ESOP and reinvests the sale's proceeds in qualified replacement property (QRP) (as defined in Sec. 1042(c)(4)), within 12 months of the sale date. T makes a timely election under Sec. 1042(a) to defer gain recognized on the sale of qualified securities to the ESOP. Under Sec. 1042(d), the basis of the QRP is reduced to reflect the deferred gain on the sale. After the Sec. 1042 election, T contributes the QRP to a partnership in exchange for a partnership interest.

Analysis

Sec. 1042(a) provides that a taxpayer or executor may sometimes elect not to recognize long-term capital gain on the sale of "qualified securities" to an ESOP (as defined in Sec. 4975(e)(7)) or eligible worker-owned cooperative, if the taxpayer purchases QRP (within the replacement period of Sec. 1042(c)(3)) and satisfies Sec. 1042(b) and Temp. Regs. Sec. 1.10421T.

A qualified securities sale meets Sec. 1042(b) requirements if: (1) the qualified securities are sold to an ESOP (as defined in Sec. 4975(e)(7)) or an eligible worker-owned cooperative; (2) the plan or cooperative owns (after application of Sec. 318(a)(4)), immediately after the sale, at least 30% of (a) each class of outstanding stock of the corporation (other than stock described in Sec. 1504(a)(4)) that issued the securities or (b) the total value of all the corporation's outstanding stock (other than stock described in Sec. 1504(a)(4)); (3) the taxpayer files with the Secretary a verified written statement of the employer whose employees are covered by the ESOP or an authorized officer of the cooperative, consenting to the application of Sets. 4978 and 4979A for such employer or cooperative; and (4) the taxpayer's holding period for the qualified securities is at least three years (determined as of the time of the sale).

Sec. 1042(c)(1) provides that qualified securities are employer securities (as defined in Sec. 409(1)), issued by a domestic C corporation with no stock outstanding that is readily tradable on an established securities market and that were not received by the taxpayer in a distribution from a plan described in Sec. 401(a) or a transfer pursuant to an option or other right to acquire stock to which Sec. 83, 422 or 423 applied (or to which Sec. 422 or 424 (as in effect on the day before the date of the enactment of the Revenue Reconciliation Act of 1990) applied).

The taxpayer must purchase QRP within the "replacement period," defined in Sec, 1042(c)(3) as the period beginning three months before the date on which the sale of qualified securities occurs and ending 12 months after the date of such sale.

Sec. 1042(c)(4)(A) defines QRP as any security issued by a domestic "operating corporation" (as defined in Sec. 1042(c)(4)(B)) that did not, for the tax year preceding the tax year in which such security was purchased, (1) have passive investment income (as defined in Sec. 1362(d)(3)(C)) in excess of 25% of the gross receipts of such corporation for such preceding tax year and (2) is not a corporation that issued the qualified securities such security is replacing or a member of the same controlled group of corporations (within the meaning of Sec. 1563(a)(1)) as such corporation.

Sec. 1042(d) provides that a taxpayer's basis in QRP, purchased by the taxpayer during the replacement period, is reduced by the gain not recognized because of such purchase and the application of Sec. 1042(a). If more than one QRP is purchased, the basis of each is reduced by an amount determined by multiplying the total gain not recognized because of such purchase and the application of Sec. 1042(a) by a fraction, the numerator of which is the cost of the property and the denominator of which is the total cost of all the properties.

Sec. 1042(e)(1) states that "[i]f a taxpayer disposes of any qualified replacement property, then, notwithstanding any other provision of this title, gain (if any) shall be recognized to the extent of the gain which was not recognized under subsection (a) by reason of the acquisition by such taxpayer of such qualified replacement property."

The legislative history of Sec. 1042(e) indicates that it was added to coordinate the requirement that deferred gain be recognized on the disposition of any QRP with other Code nonrecognition provisions. Thus, gain realized from the disposition of any QRP by a taxpayer who made an election under Sec. 1042 must be recognized at the time of the disposition, regardless of any of the Code's other nonrecognition provisions otherwise applicable.

Sec. 721(a) provides that neither a partnership nor its partners recognize gain or loss for a contribution of property to the partnership in exchange for a partnership interest.

Limited exceptions to the rule of Sec. 1042(e)(1) are provided in Sec. 1042(e)(3), which provides that the recapture rules do not apply to any transfer of QRP that occurs: (1) in any reorganization (within the meaning of Sec. 368), unless the person making the election under Sec. 1042(a)(1) owns stock representing control of the acquiring or acquired corporation and such property is substituted basis property in the transferee's hands; (2) because of the death of the person making the election; (3) by gift; or (4) in any transaction to which Sec. 1042(a) applies.

A QRP contribution to a partnership in exchange for a partnership interest is not a transfer of QRP described in any of the Sec. 1042(e)(3) exceptions.

In the present situation, T disposed of QRP by contributing it to a partnership in exchange for a partnership interest. Therefore, although this transaction is ordinarily a nonrecognition event under Sec. 721, Sec. 1042(e)(1) requires that any gain realized on the contribution be recognized to the extent of the gain deferred under Sec. 1042(a).

Holding

The transfer of QRP to a partnership in exchange for a partnership interest by a taxpayer that has elected to defer gain recognition under Sec. 1042(a) is a disposition of the QRP under Sec. 1042(e). Accordingly, any gain realized on the disposition is required to be recognized by the taxpayer at the time of the transfer, to the extent of the gain not recognized under Sec. 1042(a) because of the acquisition by the taxpayer of the QRP.

REV. RUL. 2000-18, IRB 2000-14

Abbreviations Commonly Used in The Tax Adviser

TTA             The Tax Adviser
aff'g           affirming
AFTR2d          American Federal Tax Reports, second series (RIA)
Ann.            IRS Announcement
CB              Cumulative Bulletin
Cir.            Court of Appeals
Cl. Ct.         Claims Court
COBRA           Consolidated Omnibus Budget
                Reconciliation Act of 1985
Ct. Fed. Cls.   Court of Federal Claims
DC              District Court
ERISA           Employee Retirement Income
                Security Act of 1974
Fed. Cir.       Court of Appeals for the Federal Circuit
Fed. Reg.       Federal Register
F2d             Federal Reports, second series
F3d             Federal Reports, third series
F Supp          Federal Supplement
GCM             General Counsel Memorandum
HIPAA           Health Insurance Portability and
                Accountability Act of 1996
H. Rep.         House Ways and Means Committee Report
IR              Internal Revenue News Release
IRB             Internal Revenue Bulletin
IRSRRA '98      Internal Revenue Service Restructuring
                  and Reform Act of 1998
Regs. Sec.      Treasury Regulation
Rev. Proc.      Revenue Procedure
Rev. Rul.       Revenue Ruling
rev'g           reversing
RRA             Revenue Reconciliation Act of 1993
SBJPA           Small Business Job Protection Act of 1996
Sec.            Section (refers to the Internal Revenue Code of
                  1986, unless otherwise indicated)
S. Rep.         Senate Finance Committee Report
Sup. Ct.        Supreme Court
TAM             Technical Advice Memorandum
TBOR2           Taxpayer Bill of Rights 2
TC              Tax Court (regular decision)
TC Memo         Tax Court (memorandum decision)
TD              Treasury Decision
TRA '86         Tax Reform Act of 1986
TRA '97         Taxpayer Relief Act of 1997
USTC            United States Tax Cases (Commerce Clearing House)