ESOPs and the New Tax Bill

Pros and Cons

By Ronald J. Gilbert, President ESOP Services, Inc.

3/1/2018

Special thanks to Paige Ryan for her contributions to this article.

The Tax Cuts and Jobs Act (TCJA) of 2017 makes ESOPs more attractive in 2018 and beyond for many companies, as well as their selling shareholder(s), and raises important issues for existing ESOP companies. While the TCJA made no direct changes to any specific ESOP tax-related benefit, the 21% C corporation rate will benefit many new and existing ESOP companies.

What is an ESOP?

For over 40 years, Employee Stock Ownership Plans (“ESOPs”) have been a corporate tool for obtaining significant tax advantages, while facilitating the successful transfer of some or all of the corporate ownership for tens of thousands of companies.

An ESOP is a defined contribution employee benefit plan, which is tax-qualified under Internal Revenue Code (“IRC”) sections 401(a) and 4975(e)(7). Functionally, ESOPs provide a very flexible financial and equity incentive instrument that uses corporate tax-deductible, or tax-free dollars to achieve a variety of individual and corporate objectives, including shareholder liquidity, business perpetuation, and charitable giving. Unlike any other qualified employee benefit plan, an ESOP Trust is designed to primarily hold stock of the sponsoring company, and can borrow funds to acquire the stock of the sponsoring company.

In its simplest form, an ESOP is non-leveraged.  The company establishes a trust to which it contributes stock, or cash to purchase stock. The stock is then allocated to employees’ individual accounts within the trust.

However, most ESOPs are leveraged, as most shareholders prefer to sell larger blocks of stock at one time than the non-leveraged ESOP can acquire.  A leveraged ESOP often borrows funds to purchase the stock through a loan to the corporation from a bank or other financial entity.  An ESOP is also considered leveraged when selling shareholders take back a promissory note.

Major Tax Advantages of an ESOP

Tax-Free S Corporation Income [IRC 512(a) and IRC § 409(p)]

Income attributable to stock owned by an S corporation ESOP is not subject to federal tax.[1]

Tax-Deductible Loan Payments [IRC § 404(a)(9)]

Contributions used to make ESOP loan principal payments are tax deductible to the corporation.

“Tax-Free” Rollover of Stock Sold to the ESOP [IRC § 1042]

Shareholders of a closely-held C corporation may sell their stock to the ESOP and, under certain circumstances, pay no capital gains tax provided the proceeds are reinvested in Qualified Replacement Property (“QRP”) within 12 months after or three months before the sale to the ESOP.  QRP generally includes the securities of operating domestic, public or private corporations. There are certain restrictions on how the stock was acquired, and it must be held for a three-year period prior to the sale to the ESOP. If QRP is held until the death of the original investor, the QRP receives a “stepped up basis” and the capital gains tax liability is extinguished. It is never paid, and the quotation marks are removed from “tax-free.”

Tax-Deductible Dividends When Paid Through the ESOP [IRC § 404 (k)]

Reasonable dividends on C corporation ESOP stock that are “passed through” the ESOP to participants or used to repay ESOP debt are tax deductible to the corporation. These dividends are not counted in the normal 25% of payroll contribution limit.

Forming an ESOP in 2018?

Prior to 2018, the tax-free rollover discussed above was not a viable option for many S corporations due to the requirement to convert to a C corporation prior to the sale of stock to the ESOP.  However, the lower C corporation tax rate is causing many S corporations, or LLCs that have elected to be taxed as S corporations (S corporation tax entity), to take a close look at the benefits of selling stock to an ESOP after converting to a C corporation.

In order for stockholders of a privately held corporation to be eligible to elect to defer capital gains under the tax-free rollover, the sponsoring corporation must be a C corporation at the time of the sale.  Converting to a C corporation creates future C corporation income tax liability.  Under IRS rules, a corporation that converts from S to C corporation tax status cannot convert back to an S corporation for five years.

Five-Year Requirement Usually Too Costly

Over the past 20 years, ESOP Services, Inc. has conducted a number of “S to C” feasibility studies. Most have shown that converting to a C corporation is too costly to the corporation, despite significant potential tax savings to the selling shareholders. After making the maximum annual tax-deductible contribution to the ESOP, the income tax cost to C the corporation was frequently too high to justify conversion. By remaining an S corporation, companies enjoy the tremendous benefit of tax-free income because the percentage of stock owned by an S corporation ESOP is not subject to federal income tax, and most states mirror this treatment.

With the new lower C corporation tax rate of 21%, many more S corporation tax entities will be able to justify converting to a C corporation due to the lower taxes the C corporation will pay for five years, and thus providing the selling shareholders the benefit of the tax-free rollover.

Tax Savings Up to 37%

The “tax-free” rollover allows sellers to defer capital gains tax.  Because long-term capital gains rates are essentially unchanged under the tax law, tax savings for individuals can go as high as 25-37%[2], depending on the state of residence and the basis of the stock sold to the ESOP.  (The higher the basis, the lower the potential capital gains tax savings.)  The example below measures the tax-free rollover savings realized by the selling shareholders versus the capital gains tax that would be paid.  The selling shareholder savings must then be measured against the corporate taxes that the C Corporation will pay under the 21% federal tax rate and state tax rate.

Example:

Other factors can often influence the comparison, such as the financing structure and cash flow to the selling shareholders(s), and the selling shareholders’ and family members’ potential ESOP account balances.  Every situation must be carefully analyzed based on corporate and shareholder information and objectives.  In some cases, remaining an S corporation will be the best option.

ESOPs Are A More Competitive Buyer

Electing the tax-free rollover can also lead to higher net proceeds versus a sale to an outside buyer – as much as 25% to 37% higher if the proceeds of the outside sale are subject to capital gains taxes.  To match the proceeds from the ESOP transaction, the outside buyer may need to pay as much as 25% to 37% more for the company to give the selling shareholders the same net proceeds.

Impact of State and Local Tax Limitations

The TCJA limits the amount of state and local income taxes that can be deducted from an individual’s gross income to $10,000 (including property taxes).  This in some instances can make the election of the “tax-free” rollover more attractive. Under federal law, state income and property taxes paid may be deducted from income.  With the new $10,000 limitation individuals may recognize additional income and will be subject to additional federal taxes.

If an owner in California sells $10M in stock and does not elect the ESOP “tax-free” rollover, the seller would normally pay income tax based on a top California marginal rate of 13.3%, resulting in $1,300,000, or more, in state taxes. Under prior law, the $1,300,000 of state tax would have been deductible from the seller’s federal gross income, reducing taxes by $481,000, at the 37% rate.  Under the new law the deduction from federal gross income would be limited to $10,000, resulting in a $471,000 lower deduction and federal tax rate that would be several points higher, approaching 40%.

Limitations on Interest Deductions

Consideration will need to be given to structuring ESOP loans to remain within the allowable deduction for interest expense.  The TCJA now limits the interest deduction to 30% of EBITDA for the next 4 years, and to 30% of EBIT (not EBITDA) thereafter.  This is not an issue for 100% ESOP owned S corporations, as they do not pay federal tax, and most states mirror the federal law in this regard.  However, the interest deduction limit can be a consideration for highly leveraged partial S corporation or C corporation ESOPs.  Exceeding the 30% limit means that the company will pay additional taxes. Alternatives such as payment in kind (PIK) interest may be a strategy to address the issue.

Impact to Existing ESOPs

S to C

Some S corporations with partial ESOP ownership may be considering converting to C corporation status to take advantage of the new lower C corporation tax rates.  Primary considerations for these companies include the 20% S corporation income exemption, the timing of any contemplated future ESOP transactions, the impact of other tax changes, (including new TCJA provisions placing limitations on interest deductions to 30% of EBITDA and the individual state tax rates), and the structure of current ESOP and non-ESOP debt amortization.  A 100% ESOP- owned S corporation would gain no advantage in converting.

C to S

C corporations that complete a partial ESOP transaction often convert to S corporation status effective the beginning of the following fiscal year.  For corporations with a calendar fiscal year, if the conversion takes place prior to March 15th, the effective date of the conversion is the 1st of January immediately prior to that March 15th.  With the 21% C corporation tax rate, the tax savings realized by a partially ESOP-owned C corporation converted to an S corporation will be reduced.  However, the 20% S corporation income tax exemption (which does not apply to all S corporations) could increase net income to an S corporation and its shareholders.  A thorough analysis is required before an informed decision can be made regarding conversion.  If, however, a C corporation has become 100% ESOP owned, conversion to an S corporation on January 1 of the following year, or sooner, will almost always will be the recommended course of action.

Greater Shareholder Value for ESOP Participants

All other factors being equal, a lower C corporation tax rate will result in a greater net profit.  Obviously, this will increase the value of the shares owned by the C corporation ESOP, and thus increase the value of individual ESOP participants’ accounts.

Less obviously, the value of shares owned by the ESOP in most S corporations should increase as well. ESOP valuations normally rely, at least in part, on projected after-tax net income (public company comparisons are usually used as well), and independent ESOP valuation firms “tax affect” the S corporation earnings.  This means that even in a 100% ESOP-owned S corporation that pays no federal or state income tax, the assumption is that C corporation taxes are paid for valuation purposes  A lower C corporation tax rate could mean greater shareholder value for most S corporations, although there will not be any actual increase in S corporation net income.

Increased Repurchase Obligation

An increase in projected stock value will have a direct impact on the company’s ESOP repurchase obligation. Repurchase obligation is the requirement that ESOP participants have their stock accounts “cashed out.”  This means that ESOP repurchase obligation studies and projections will need to be updated.  Keep in mind that the corporation has the obligation to see that ESOP participants receive their payouts due to retirement, death, disability, “other” terminations, and age 55-60 diversification.  Many corporations make contributions to the ESOP to fund the repurchase obligation, but it is the corporation that must ultimately ensure that the cash is available to meet the obligation.

ESOPs Today and in the Future

The brain child of Louis Kelso, ESOP’s became law in 1974 under the sponsorship of Senator Russel Long, D, LA, under the Employee Retirement Income Savings Act (“ERISA”).  Today ESOP’s cover roughly 14 million participants in over 6,700 companies. [3]

According to the National Center for Employee Ownership (esopinfo.org) ESOP companies are 25% more likely to stay in business, employee-owners were four time less likely to be laid off during the recent recession, employees in ESOP companies have two and one-half times greater retirement accounts , and wages are 5%-12% higher in ESOP companies.

In Joseph R. Blasi, Douglas L. Kruse and Richard B. Freeman’s recent article “Having a Stake: Evidence and Implications for Broad-based Employee Stock Ownership and Profit Sharing,” they argue that the time has come to further encourage Employee Stock Ownership Plans. There is evidence that ESOP’s provide the incentives for greater effort, more cooperation, more innovation and more sharing – all of which contribute to improvements in workplace performance and company productivity.

Continued Bipartisan Support for ESOPs

ESOPs are one of the few things in Washington, DC that have strong bipartisan support ranging from Republican Speaker of the House Paul Ryan to independent Senator, and former presidential candidate, Bernie Sanders.  Pending legislation in the House of Representatives, HR-2092, has over 40 cosponsors from both parties, and the companion bill in the Senate, S-1589, has more than 25 Republican, Democratic, and independent cosponsors.  If enacted the legislation would make ESOPs even more attractive than they are today.

In states including Colorado, Iowa, Massachusetts, Missouri, Pennsylvania and Texas, we have seen a growth in ESOP related initiatives. [4]

What Next?

Companies contemplating a first-time ESOP transaction in 2018, as well as existing ESOP companies considering converting from S to C or C to S, should consult with all their professional advisors to make certain their shareholders, management, and board of directors have all the facts necessary to make an informed decision.

 

The contents of this article should not be considered as tax, accounting or legal advice.

 

Contact Information:

RONALD J. GILBERT

ESOP Services, Inc.
President and Cofounder

251 Albevanna Lane
Scottsville VA 24590
esop@esopservices.com

434-286-3130

 

[1] IRC 409(p) is a statute designed to prevent the use of an ESOP to disproportionately benefit a small group of employees.

[2] 20% Federal, 13.3% California, and 3.8% Medicare Sur Tax.

[3] https://www.nceo.org/articles/recent-employee-ownership-legislation-u-s

[4] https://www.nceo.org/articles/recent-employee-ownership-legislation-u-s