ESOP Benefit Cut by Biden’s Tax Plan

Vice President Biden’s tax plan contains a major cut back for a key ESOP tax benefit, the “tax-free” rollover (IRC 1042). Over the past 36 years this ESOP tax benefit has been responsible for many of the ESOPs now in place, and the cut back would dramatically reduce new ESOP formation, deprive thousands of employees the opportunity to become employee owners, and could negatively impact the many individuals who sold their stock to the ESOP and reinvested the proceeds under the “tax-free” rollover rules.

Capital Gains Tax Extinguished at Death

What makes the “tax-free” rollover so popular with the owners of mostly small and mid-sized companies, and allows ESOPs to compete successfully against outside buyers, is the eligible seller’s ability to reinvest the proceeds in stocks and bonds of U.S operating companies and hold the reinvested portfolio, called Qualified Replacement Property (QRP), until death. At death the seller’s estate receives a stepped-up basis. As a result, the capital gains tax is extinguished, IT IS NEVER PAID.

New ESOP Formation

It is the stepped-up basis at death, proposed to be eliminated under the Biden plan, that allows the ESOP to be competitive with outside buyers seeking to acquire a privately-held company. The combined federal and state capital gains tax is approximately 30% in most states. The “tax-free” rollover allows the ESOP to pay less than the outside buyer but the sellers, who would normally pay capital gains tax to an outside buyer, to net as much or even more from the sale to the ESOP.

Existing QRP Holders

A major attractive feature for the individuals who have elected the “tax-free” rollover was the stepped up basis at death. Their estate planning will be dramatically affected if the stepped up basis is eliminated.

Bipartisan Support

Democratic Senator (LA) Russell Long championed the tax-free rollover, and Republican President Ronald Reagan signed it into law in 1984. ESOPs have always had strong bipartisan support. The Biden elimination of stepped up basis and its negative impact on future ESOP formation and existing holders of QRP portfolios is a major departure from the historic bipartisan support of ESOPs.