Authored by Matt Waters
For founders who have built meaningful value in a closely held business, the hardest part is often not growth, but deciding how to step into liquidity without blowing up everything that made the business worth owning in the first place.
Section 1042 of the Internal Revenue Code sits at that exact intersection. When implemented appropriately, it can be an efficient structure. When it doesn’t, it’s usually because it was treated like a tax move instead of what it really is: a long-term ownership and estate strategy.
This is not about gaming the system. It’s about structuring a transition that aligns capital, control, people, and legacy.
What a 1042 Plan Really Is (and Isn’t)
At its core, a 1042 transaction allows a shareholder of a C-corporation to sell stock to an Employee Stock Ownership Plan and defer capital gains taxes, provided the proceeds are reinvested into Qualified Replacement Property within the required window.
That sentence undersells what’s happening.
Economically, the founder is exchanging a concentrated ownership position in a single operating company for a diversified portfolio of operating-company securities, while the business itself transitions to partial employee ownership. The IRS’s role is simply to reward that behavior by stepping out of the way on taxes, at least for now.
It is not tax avoidance. It is tax deferral, with the possibility that the tax is never paid if the strategy is coordinated correctly with the founder’s estate plan.
A More Complete 1042 Example
Consider a founder who owns 80 percent of a C-corporation valued at $40 million. The business has consistent cash flow, a solid management bench, and no desire to sell to private equity. The founder wants liquidity, but not a clean exit. Control still matters. Culture matters. Employees matter.
Instead of selling the entire company, the founder sells 30 percent of the outstanding shares to an ESOP for $12 million.
The ESOP does not show up with a suitcase of cash. The purchase is typically financed through a combination of third-party bank debt, a seller note, and future company cash flow. The company itself repays the ESOP debt over time, using profits it would have otherwise distributed or reinvested.
From the founder’s perspective, the transaction closes, liquidity is created, and a Section 1042 election is made. The $12 million in proceeds is reinvested into Qualified Replacement Property within the allowable timeframe. Capital gains that would have been immediately taxable are deferred.
Post-transaction, the founder still owns 50 percent of the company, retains voting control, and remains CEO. Employees now have a meaningful ownership stake, not in theory but economically. The company continues operating. No press release. No culture shock. No new overlords.
What has changed is the founder’s balance sheet. A single illiquid operating asset has been partially converted into a diversified, income-producing portfolio, while preserving upside in the remaining equity.
This is not an exit. It is a recalibration.
The Role of Qualified Replacement Property
The success or failure of a 1042 transaction often hinges on what happens after the sale.
Qualified Replacement Property must consist of securities issued by U.S. operating companies. This excludes most of what high-net-worth investors instinctively think of as diversification. Public market ETFs, mutual funds, real estate, private funds, and anything exotic are off the table.
In practice, sophisticated founders typically use custom-designed 1042 note structures that provide exposure across multiple operating companies, generate income, and avoid single-issuer concentration risk. The goal is not aggressive growth. It is stability, predictability, and alignment with long-term estate objectives.
This is where careful structuring and coordination are critical. Poorly constructed QRP portfolios create frustration. Well-constructed ones are designed to align with long-term planning objectives.
When This Strategy Makes Sense
A 1042 plan becomes compelling when the founder already thinks in long arcs. The business has dependable cash flow. The management team is capable of running without constant founder intervention. The founder wants liquidity but still cares deeply about the company’s future and people.
Transaction size matters. Below a certain threshold, the fixed costs and ongoing compliance simply don’t justify the structure. Above it, the economics become difficult to ignore.
Just as important is temperament. This strategy rewards patience, discipline, and coordination. Founders who want a clean break or immediate disengagement usually find this structure constraining rather than empowering.
When It Doesn’t
This approach breaks down quickly when the business is unstable, when conversion from an S-corp is rushed, or when the founder’s only motivation is tax savings. A 1042 plan layered onto a weak operating company or an unclear personal vision almost always disappoints.
This is not a financial product. It is an ownership philosophy wrapped in tax code.
Integrating a 1042 Plan with the Founder’s Estate Plan
Where Section 1042 becomes truly powerful is when it is intentionally woven into the founder’s estate plan.
Because capital gains are deferred on the QRP, the founder has flexibility in how wealth ultimately transfers. If the QRP is held until death, the embedded gain may receive a step-up in basis, effectively eliminating the original capital gains tax altogether. That alone can materially change how much wealth passes to heirs.
Beyond taxes, QRP assets can be placed into trusts, used to equalize inheritances among children who are and are not involved in the business, or paired with charitable strategies for further planning flexibility. Meanwhile, the remaining operating company shares can be transitioned separately, whether to family members, management, or eventually the ESOP itself.
In other words, a 1042 transaction can decouple liquidity planning from succession planning. That separation is often what allows founders to make better decisions in both domains.
The Bottom Line
Section 1042 is not clever. It is deliberate.
For the right founder, it offers a rare combination: liquidity without surrender, tax efficiency without gimmicks, and a way to align personal wealth planning with the long-term health of the business and the people inside it.
For the wrong founder, it is an expensive reminder that complexity does not create clarity.
The real question is never whether a 1042 plan is available. It is whether the founder is ready to think beyond the transaction and design an outcome that still makes sense twenty years from now. That’s where this strategy earns its keep.
If you have more questions about 1042 plans, contact our team of financial advisors in Denver today.
This information does not constitute legal advice. Prime Capital Financial and its associates do not provide legal advice. Individuals should consult with an attorney regarding the applicability of this information for their situations.
Advisory products and services offered by Investment Adviser Representatives through Prime Capital Investment Advisors, LLC (“PCIA”), a federally registered investment adviser. Tax planning and preparation services are offered through Prime Capital Tax Advisory. PCIA: 6201 College Blvd., Suite 150, Overland Park, KS 66211. PCIA doing business as Prime Capital Financial | Wealth | Retirement | Wellness | Family Office | Tax Advisory.
