1042 treatment of note

[Guest Mike Cain]

A client of ours sold his stock in a small company to a newly created ESOP. 30% of the sale proceeds were in the form of a note. The terms of the note do not require any payments during the first 12 months. The balance of the proceeds (70% cash) were investing in qualifying 1042 securities. If he purchases additional qualifying securities with the note proceeds, will it qualify for the 1042 deferral? (Even though the proceeds won't be collected within the 12 period following the sale?)

And, can the 30% which was sold for a note qualify as an installment sale? (Assuming we don't get the 1042 deferral.)

Any comments are welcome. Thank you.

[RLL]

1042 tax-deferred treatment is available only to the extent that qualified replacement property ("QRP") is purchased within 12 months after the sale date (or in the 3 months before the sale). The fact that proceeds of the note will be received in a subsequent year does not extend the 12-month period. The seller may use other assets (or borrowed money) to pay for the additional QRP before receiving the note proceeds.

The seller may treat the sale as an installment sale. However, the 30% piece represented by the note is not a separate installment sale, but is part of the total sale. If only the cash proceeds are reinvested in QRP, the taxpayer will still have a partially taxable gain in the year of the sale because IRC Sec. 1042(a) provides that gain will be recognized to the extent that the amount realized on the sale (including the portion represented by the note) exceeds the cost of QRP. The portion that is not taxable in the year of the sale can be recognized as taxable gain as the note proceeds are received. The tax computation is a bit complicated.