Selling to an ESOP in 2026: Deal Math, Section 1042, and the Repurchase Obligation

An employee stock ownership plan (ESOP) lets a private company's owner sell shares to a trust that holds them for employees. It gives the owner a buyer when there is no family successor and a sale to a competitor or private equity firm is unappealing, and it comes with tax benefits no other buyer can offer. It also has real limits: the price is capped at an independent appraiser's fair market value, the company usually takes on debt to fund the purchase, and it must eventually buy back every share from departing employees.

The National Center for Employee Ownership counts about 6,600 ESOPs covering 15.1 million participants, based on 2023 filings, with around 300 new plans a year. This guide covers how the deal works, the tax rules in 2026, the repurchase obligation, and the valuation changes of the past year. For the other exit routes, see our business succession guide.

How a leveraged ESOP sale works

1. Feasibility. Advisors test whether the company's cash flow can support the debt and whether the likely appraised value meets the owner's needs.
2. Trustee and valuation. An independent trustee represents the ESOP and hires its own appraiser. The ESOP may pay no more than fair market value, which ERISA calls "adequate consideration."
3. Financing. The company borrows from a bank and lends the money to the ESOP, often alongside a seller note from the owner.
4. Purchase. The ESOP buys the owner's shares.
5. Repayment. The company makes annual tax-deductible contributions to the ESOP, which uses them to repay the loan. Shares are released from a suspense account and allocated to employees' accounts as the debt is paid.

The owner does not have to sell everything at once. Many sales start at 30% to 100%, and many owners keep running the company for years afterward.

An illustration: a 40% sale

A C corporation earns $5 million a year before interest, taxes, depreciation, and amortization (EBITDA), and an appraiser values it at $30 million. The owner sells 40% to an ESOP for $12 million, funded by a bank loan at 7% over seven years.

• Annual loan payments come to about $2.23 million, roughly 45% of EBITDA, leaving the rest for taxes, capital spending, and working capital.
• In year one, about $840,000 of the payment is interest and $1.39 million principal. For a C corporation, contributions used to repay principal are deductible up to 25% of covered payroll, and interest is deductible on top. With an $8 million payroll, the principal limit is $2 million a year.
• The owner's basis in the shares sold is $1 million, so the gain is $11 million. At the top federal rate of 23.8% (20% plus the 3.8% net investment income tax), that is $2,618,000 of tax, which Section 1042 can defer, as described below.

Tax rules in 2026

Section 1042 for C corporation sellers

Section 1042 lets a seller defer capital gains tax on a sale to an ESOP if:

• The company is a domestic C corporation with no readily tradable stock.
• The seller has held the shares for at least three years.
• The ESOP owns at least 30% of the company's stock after the sale.
• The seller buys qualified replacement property (stocks or bonds of US operating companies) during the window from 3 months before to 12 months after the sale.
• The shares bought in a 1042 sale are not allocated to the seller, the seller's family, or other 25% shareholders.

The deferred gain carries over into the replacement securities. Selling them triggers the tax; holding them until death means heirs receive a stepped-up basis and the deferred tax is never paid. Some sellers buy long-dated floating-rate notes designed for this purpose, then borrow against them to regain liquidity. If the ESOP sells the shares within three years, the company can owe a 10% excise tax. Our estate planning guide covers how replacement property fits an estate plan.

S corporations

Section 1042 does not apply to S corporation stock today. SECURE 2.0 extends it to S corporations for sales after December 31, 2027, but limits the deferral to 10% of the amount realized (Morgan Lewis summary). On a $12 million sale, that is $1.2 million.

S corporations have a different advantage. Their income passes through to shareholders, and the ESOP trust is tax-exempt, so the ESOP's share of profits is not taxed federally. A company 100% owned by an ESOP pays no federal income tax: on $3 million of pretax profit, that saves $630,000 a year compared with the 21% C corporation rate. Many companies sell to an ESOP as a C corporation to use Section 1042, then convert to an S corporation once the ESOP owns 100%. Anti-abuse rules in Section 409(p) stop a few insiders from capturing the benefit through synthetic equity or concentrated allocations.

Other deductions

For C corporations, dividends paid on ESOP shares and used to repay the ESOP loan, or passed through to participants, are also deductible. Employees pay no tax until they receive distributions, which they can usually roll into an IRA.

The repurchase obligation

Employees cannot sell private company stock on a market, so Section 409 gives them a put option: the company must buy the shares at the current appraised value when they are distributed. Distributions must generally start within one year after the plan year of retirement, disability, or death, and by the sixth plan year after other separations, and can be paid in installments over up to five years.

This is a real liability that grows with the company's success. A rising share price, an aging workforce, and several retirements in a weak year can combine into a cash squeeze. Ways to manage it:

• Commission a repurchase obligation study every few years, forecasting payouts over at least ten years.
• Build the forecast into your cash planning; see our cash flow management guide.
• Choose a funding approach: redeeming shares (the company buys and retires them), recycling them through the ESOP with cash contributions, or releveraging with a new loan.
• Set distribution policies, such as installment payments, that the plan document allows.

Valuation rules: what changed in 2025 and 2026

Valuation has been the main source of ESOP litigation. Trustees who let an ESOP overpay have been held liable; in Brundle v. Wilmington Trust (2019), the Fourth Circuit upheld a judgment of about $29.8 million against a trustee. The Department of Labor has never finalized a rule defining adequate consideration for private company stock. A proposal released in January 2025 was withdrawn before publication, and the department's agenda now targets a new proposal for November 2026.

Two 2026 developments have eased the pressure:

• Enforcement. The DOL removed ESOPs from its national enforcement projects in January 2026, and its Field Assistance Bulletin 2026-01 of April 14, 2026 told investigators to review ESOP valuation cases under a principle of fairness until the department issues valuation standards.
• Legislation. The Retire Through Ownership Act, which lets ESOP fiduciaries rely in good faith on an independent appraiser's valuation that follows IRS Revenue Ruling 59-60, passed the Senate in October 2025 and the House 401-14 on September 16, 2026. As of late September 2026 it was awaiting the President's signature. It does not change fiduciaries' general duty of prudence.

For sellers, a well-documented independent appraisal matters as much as ever. Expect the trustee to question management's projections and to negotiate the price, and note that the ESOP generally cannot pay a control premium unless it actually gets control. Our business valuation guide covers the methods appraisers use.

Is an ESOP a fit?

ESOPs tend to work for companies with:

• Steady, predictable cash flow that can carry acquisition debt
• A management team that can run the business without the owner
• Enough employees and payroll to justify the costs; below roughly 20 employees, the fixed costs are hard to justify
• An owner willing to accept appraised fair market value, which may be below what a strategic buyer would pay

They fit poorly when a strategic buyer will pay well above fair market value, when cash flow is volatile or needed for heavy capital spending, or when the owner needs all the cash at closing and will not accept a seller note.

Expect significant professional fees to set up the plan (legal, valuation, trustee, and financial advisory), and recurring costs for the annual independent valuation, recordkeeping, and plan audit.

Timeline and next steps

A typical ESOP sale takes six to twelve months:

1. Run a feasibility study with an ESOP-experienced advisor, covering value, debt capacity, and repurchase obligation.
2. Hire ERISA counsel for the company and choose an independent trustee, which hires its own appraiser and counsel.
3. Negotiate price and terms with the trustee, and arrange bank financing and any seller note.
4. Close the transaction, adopt the plan document, and file the Section 1042 election if you qualify.
5. Explain the plan to employees. Companies that share financial information and train employees on how the business makes money tend to get more from employee ownership.
6. Set up the annual cycle: valuation, administration, repurchase planning, and trustee oversight.

This guide is for informational purposes only and does not constitute legal, tax, or investment advice. ESOP rules are complex, and the law and DOL guidance were changing as of September 2026. Consult experienced ERISA counsel, a CPA, and an independent valuation advisor before starting an ESOP transaction.