Federal Income Tax Update
I. Sections 453 and 1042 Deferral Provisions Can Apply in the Same ESOP Transaction; Berman vs. Commissioner, 163 TC No. 1 (2024).
In 2002, Mr. and Mrs. Berman sold their closely held C corporation stock to an ESOP for promissory notes. They did not receive any sale proceeds in 2002. They purchased qualified replacement property (“QRP”) in an amount equal to or exceeding the gain on the sale of stock to the ESOP. However, some of the QRP purchases did not occur until after the 12-month QRP replacement period. The Bermans elected pursuant to Section 1042 to defer recognition of the entire gain on the ESOP sale. They reported no taxable income from the stock sale to the ESOP.
In 2003, each of Mr. and Mrs. Berman received approximately $450,000 under the ESOP promissory notes. The Bermans used their QRP as collateral for a 90% loan, allowing the lender to keep the remaining 10% as a loan fee. The Bermans later conceded the cash-out loan they collateralized with their QRP was a disguised sale of the QRP. The IRS took the position the cash-out loan caused the Section 1042 deferred gain to be fully recognized in 2003 under the recapture rule of Section 1042(e). The Bermans took the position their 2003 gain should be limited to the $450,000 payments under the installment notes.
The Tax Court agreed with the Bermans. The court stated Sections 453 and 1042(a) are not mutually exclusive. Section 1042 acts to defer gain that otherwise would be recognized under the installment method. By not reporting any of the gain in 2002, the Bermans did not elect out of Section 453, thus allowing the deferral of gain until future note payments were received.