(11/12/08)
Ronald J. Gilbert
Forces are marshaling for legislative attacks on ESOPs when the new Congress convenes in January of 2009. The severity of the attacks and whether or not they will succeed are unknown. However, the attacks could well be severe. They could succeed. They could be launched at the beginning of the new Congressional session, and the cutbacks could be retroactive to January 1, 2009.
What We Know
The very powerful Chairman of the Ways and Means Committee of the House of Representatives, Charles Rangel, introduced an anti-ESOP provision in 2007 that would cut back some of the benefits available to S Corporation ESOPs. Both Democratic and Republican Congressmen have assured us that the bill will be reintroduced in the new session.
What We Do Not Know
What else might be attacked is unknown. This author feels that S Corporation ESOPs are most likely to be attacked, followed by the IRC 1042 “tax-free” rollover.
About ninety percent of all ESOPs are in small businesses with fewer than five-hundred employees. A substantial number of these ESOPs are sponsored by S Corporations. The new administration is on record as favoring tax increases for small businesses. The revenue that can be gained by cutting back S Corporation ESOP benefits is minimal. However, because Mr. Rangel has already proposed cutbacks in 2007, it is not difficult to imagine Mr. Rangel and his staff proposing additional ESOP cutbacks for S Corporations in the name of “fairness.”
The IRC 1042 “tax-free” rollover is also a small business benefit that is only available to privately-held companies. The rollover entered the 1984 tax code because Senator Russell Long, the legislative father of the ESOP, wished to “level the playing field.” Prior to 1984, the only practical way a small business owner could execute a tax-deferred stock swap and sell their company was to sell to a large publicaly-traded company. Capital gains taxes on the stock they received in the stock swap were deferred until such time they sold the publically-traded stock. The stock swap was a huge incentive for small businesses (which many of us believe are one of the most productive elements of our economy) to sell out to large publically-traded companies.
The “tax-free” rollover of stock sold to an ESOP allows owners of privately-held companies to reinvest their proceeds in the stock or bonds of U.S. operating companies and to get the same tax benefits (no more or no less) as a stock swap with a publically-traded company. If the ESOP “tax-free” rollover benefit were eliminated, owners of privately-held companies who were unable to execute a stock swap with a publically-traded company would pay higher taxes on the sale of their companies.
Good News
Historically, whenever an ESOP benefit has been cut back, whatever was in place was grand fathered. Mr. Rangel’s 2007 ESOP cutback proposal specifically states that anything in place prior to date of enactment is grandfathered. Presumably this same language will be added in ESOP cutback proposals introduced in the new Congress. However, it is very important to understand what has been traditionally grandfathered, and an empty ESOP is no protection. (An empty ESOP is an ESOP that has been adopted by the company’s board of directors but owns no stock.)
What would be grandfathered by the Rangel proposal is the financing arrangements and any other synthetic equity already in place upon date of enactment of a new bill. Applying this approach to new legislation would mean that if an ESOP owned forty percent of the stock of an S Corporation on March 31, 2009, and the special tax status of ESOP-owned S Corporations were eliminated on April 1, 2009, then the special tax status would be retained for the forty percent of the shares already owned. If the ESOP bought the remaining shares of the company on July 1, 2009, the remaining sixty percent of the ESOP-owned stock would not enjoy the special tax status.
Tsunami Effect
Another major concern is the “Tsunami effect,” in which ESOPs get caught up in the major tax bill that will come out of the Ways and Means Committee early next year. (Leading Democrats have already held hearings about reducing tax deductions on 401(k) deferrals.)
Strategy
Our firm is experiencing one of the busiest fourth quarters in my thirty years as an ESOP consultant. Business owners who have been considering an ESOP for the last few weeks or few years have decided that now is the time to act. Many experts believe that the coming tax increases will not be retroactive to January 1, 2009, and that we have at least until April 1, 2009, to structure ESOP transactions that would be grandfathered. I have no crystal ball, and I cannot be certain that cutbacks will occur. We must assume, however, that when statements regarding tax increases are repeatedly made by Democratic Congressional leaders, including Charles Rangel or the President elect of the United States, that they mean what they say.