Skip to content

Student Question of the Week: Retirement Planning

Student Question from: Natalia G.
Course:  Retirement Planning – Characteristics of ESOPs

Student Question:

Quick question – under “Recognition deferral” paragraph (below in bold), it is stated that ESOP plan participants can “defer recognition of a portion of their gains when employer securities are distributed at retirement. Participants are generally eligible to delay recognition of gain on unrealized appreciation until the subsequent sale of the shares of sponsor stock.” What is the retirement plan-specific feature in this arrangement? Economic gains are not taxable until securities are sold in any type of brokerage account, right?   

RECOGNITION DEFERRAL

One of the unique features of an ESOP plan is the possibility for participants to defer recognition of a portion of their gains when employer securities are distributed at retirement. Participants are generally eligible to delay recognition of gain on unrealized appreciation until the subsequent sale of the shares of sponsor stock. .


Instructor Response:

Hi Natalia! 

Very good question!  You are correct. As a general rule, a shareholder must recognize capital gain from the sale of shares. However, if the sale is from a closely-held C Corp shareholder to an ESOP, there is a plan-specific exception to the general rule. Such a shareholder may defer recognition of capital gain if qualified replacement securities are purchased with the sale proceeds.

For example, assume that a closely-held C Corp shareholder receives $2,000,000 from the sale of shares to an ESOP. Further assume that the realized gain on the sale is $1,800,000. If the shareholder takes the $2,000,000 in cash proceeds and purchases qualified replacement securities, there will be no recognized gain from the sale of shares to the ESOP.

Noteworthy: The gain is deferred rather than avoided. The $1,800,000 capital gain is recognized when the qualified replacement securities are sold in the future. This exception allows closely-held C Corp shareholders to diversify out of a single stock position on an income tax-deferred basis. The purpose here is to incent the use of ESOPs.

Qualified replacement securities are defined as equity or debt securities of U.S.-based businesses or governments that are traded on U.S. exchanges.