The pro-ESOP proposal is H.R. 3111 in the House and S. 1319 in the Senate.
Congressional allies of employee ownership through ESOPs have introduced the ESOP Promotion and Improvement Act of 2005 in both the Senate and the House. The primary sponsor in the Senate is Senator Blanche L. Lincoln (D-AR) and the primary sponsor in the House is Representative Nancy L. Johnson (R-CT). Mrs. Johnson was joined by Representatives Jim McCrey (R-LA) and William J. Jefferson (D-LA).
Below is a section by section analysis of the new pro-ESOP legislation.
Section 1: Titles the bill the Employee Stock Ownership Plan and Improvement Act of 2005.
Section 2: Repeals the punitive 10% penalty tax on S corporations of distributions from current earnings, also referred to as dividends, paid on ESOP stock that are passed through to ESOP participants in cash.
Section 3: Clarifies that dividends paid by C corporations on ESOP stock are not a preference item in calculating the corporate alternative minimum tax.
Section 4: (a) Permits sellers of stock to the ESOP of an S corporation to utilize the ESOP tax benefit referred to as the tax deferred rollover, or the 1042 treatment. (b) Permits proceeds received from a 1042 transaction to be invested in mutual funds consisting of operating US corporation securities. (c) Redefines who is a 25% or more owner for purposes of IRC 1042 to be 25% or more ownership of voting stock, or 25% or more ownership of all stock of the corporation, not 25% of any class of stock.
Section 5: Permits early withdrawals from ESOPs, as with other ERISA plans, for first time home purchase or payment of college tuition, with various restrictions. The withdrawal may not be more than 10% of account balance, and the individual has had to have participated for five years in the ESOP.
Section 6: Increase the de minimums amount exempt from mandatory ESOP diversification requirements from ESOP balances from $500 to $2,500 per account.
The Association’s President, J. Michael Keeling, urges all advocates of ESOPs to write their Member of Congress and ask for support of this pro-ESOP legislation.
Explanation of Rationale of H.R. 3111 & S. 1319, Section by Section
Section 1: The title, “the ESOP Promotion and Improvement Act of 2005”
Section 2: Under current law since 1984, when a C corporation pays dividends on an employee’s stock in an ESOP, and the employee receives the dividends in cash, the employee pays regular income tax on the dividends; but if the employee works for an S corporation that sponsors an ESOP, and the employee owner receives a “dividend” on ESOP stock, the employee owner will pay regular tax plus a 10% penalty tax. Section 2 eliminates the 10% penalty tax on the employee owner’s dividends received on ESOP stock paid by an S corporation. There is ample legislative history that Congress in enacting the 1997 law permitting S corporations to sponsor ESOPs never intended to impose a penalty tax on dividends paid to employee owners.
Section 3: The IRS interprets a 1989 law as imposing the corporate alternative minimum tax on dividends paid on ESOP stock. There is little legislative history to support the view that Congress wanted to discourage the paying of dividends to employee owners participating in an ESOP. Section 3 clarifies that the 1989 corporate AMT law did not sanction taxing ESOP dividends.
Section 4(a): Current law since 1984 permits the owner of privately-held C corporation stock sold to an ESOP to defer his or her capital gains tax if after the sale the ESOP owns at least 30% of the C corporation, and the seller reinvests the proceeds in another U.S. operating corporation; but the 1997 law permitting S corporations to sponsor ESOPs does not provide this opportunity for owners of S corporation stock. Section 4(a) conforms the S ESOP law to the C ESOP law. (Data indicates that approximately 75% of the ESOP companies created in America were incentivised by this provision of law, known as the ESOP tax deferred rollover law.)
Section 4(b): The 1984 law referenced above was enacted before the boom in mutual funds, and does not permit the proceeds of the seller to be reinvested in mutual funds. Section 4(b) would modernize the 1984 law by permitting the proceeds from the sale to the ESOP to be reinvested in mutual funds consisting of securities of U.S. operating companies.
Section 4(c): Clarifies that anyone who owns 25% or more of the voting stock, or 25% or more of the value, of an ESOP company, cannot participate in the ESOP with stock sold to the ESOP utilizing the provision described in Section 4(a). Current law oddly prohibits the 25% or more owner of any class of stock from participation
Section 5: Current law permits a participant in a 401(k) plan to withdraw from an account limited amounts to help purchase a first home, or pay college tuition, without paying a 10% penalty tax on the withdrawn amount. Section 5 permits an ESOP to offer participants the same option.
Section 6: Current law, since 1986, imposes mandatory diversification rules on ESOP accounts for certain employees if an account balance is over $500. The $500 is not indexed for inflation, and has never been adjusted since 1987. Section 6 raises the $500 to $2,500 in order to ease one of the administrative burdens on ESOP sponsors.
Revenue Impact: While there is no formal revenue estimate on H.R. 3111/S. 1319 at this time, its revenue impact should be reasonable, as all sections amend existing law on which there are years of revenue expenditure data. None of the data on these existing ESOP laws have evidenced large revenue losses. In fact, Section 2 is forecast to raise revenue as it will trigger payment of income taxes on payments that are not being made, and on which no income taxes are currently being paid.