Employee stock ownership plans, commonly referred to as an ESOP, offer a range of benefits for sponsor companies in addition to its owners and employees. As a qualified employee benefit plan, an ESOP is designed to provide retirement benefits to employees similar to that of a 401(k) plan. However, unlike a 401(k) plan — where contributions are used to invest in a variety of outside stocks, bonds and mutual funds — an ESOP invests in the stock of its employer. As a result, employees become owners of their company, participating directly in its growth and success.
Previously, we looked at the compelling tax advantages of an employee stock ownership plan, including:
What effect, if any, does the recent Trump tax reform have on these benefits? In short, the Trump tax reform package (Tax Cuts and Jobs Act) signed into law in December of 2017 made no direct changes to these rules.
So, what has changed?
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In this article, we examine certain significant provisions under the Tax Cuts and Jobs Act and their impacts on ESOP-owned companies including:
The most notable change to the tax code was the reduction of corporate income taxes from 35% to 21% of earnings. Like any other company, lower taxes means more after-tax profit and an increase in a company’s stock value.
The most notable change to the tax code was the reduction of corporate income taxes from 35% to 21% of earnings.
For an ESOP-owned company with repurchase obligations (the obligation of the company to buy back shares of exiting employees), a higher appraisal means a higher buyback value and the need for greater cash reserves on hand. This could prove problematic for a company with minimal cash reserves and modest cash flow.
In these instances, it is advisable that a repurchase study be performed to ensure there is sufficient cash on hand or appropriate reserves to meet projected repurchase obligations. For companies considering an ESOP, this change in tax rate may have owners rethinking the value of an ESOP in light of the overall reduction in corporate taxes.
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However, ESOPs still offer significant tax advantages. This is especially true for business owners with C-corps looking to sell to an ESOP and take deferral under section 1042 of the Internal Revenue Code, which is addressed below.
Prior to the Trump tax reform, there was no limit on the deduction from gross income for state and local income taxes. Today, the law caps this deduction at $10,000. As a result, business owners looking to sell are likely to pay higher taxes on their sale proceeds. This is especially true for filers in California, New York, New Jersey, Illinois, Texas and Pennsylvania which are among the states that impose the highest income tax rates.
Owners of C-corporations looking to sell all or a portion of the business can, in the case of a sale to an ESOP, utilize section 1042 of the Internal Revenue Code and defer paying taxes on their sale proceeds for a potentially indefinite period of time. Under section 1042 of the Internal Revenue Code, a seller who uses all or a portion of their sale proceeds to purchase qualified replacement property (floating rate notes or stock or bonds of domestic operating companies) within twelve (12) months from the date of the sale does not pay taxes on such amounts.
Owners of C-corporations looking to sell all or a portion of the business can…defer paying taxes on their sale proceeds for a potentially indefinite period of time.
Similar to a section 1031 real property exchange, the purchase of qualified replacement property effectively treats that portion of sale proceeds as an asset exchange as opposed to a recognition of taxable income. Provided a seller holds the qualified replacement property until death, taxation is avoided completely as the property will be transferred to the seller’s heirs with a stepped-up tax basis. By investing in a qualified replacement property the seller can avoid all capital gains on the original sale of the stock.
Sellers can leverage their qualified replacement property to extract liquidity without triggering a tax recognition event. In certain circumstances, institutional lenders will allow a seller to borrow up to 90% of the current market value of such collateral, and borrowed funds can be used freely. With the increase in taxes as a result of deduction caps, a sale to an ESOP and subsequent section 1042 exchange means the potential for even greater tax savings.
The TCJA initially limits interest deductions to 30% of a company’s EBITDA (earnings before interest, taxes, depreciation, and amortization) and, beginning in 2022, such deduction will be based upon EBIT (earnings before interest and taxes). For highly leveraged ESOP sponsors with a large amount of debt, this may mean higher taxes. Depending on whether cash flow is significantly impacted, it may be prudent for plan sponsors to consider restructuring existing debt arrangements. Note, however, that this change remains irrelevant for 100% ESOP owned S corporations as these companies do not pay tax.
With the help of experienced advisors, plan sponsors and business owners can successfully navigate the new tax reform to continue to utilize ESOPs as effective tax savings vehicles.
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Shannon R. Weiss is an associate at Vedder Price and a member of the Finance & Transactions group in the firm’s Los Angeles office. Ms. Weiss represents sellers, buyers, investors, and private equity and venture capital funds in purchases and divestitures, restructurings and joint ventures. She regularly counsels ESOP-owned corporations with respect to recapitalizations, acquisitions,…
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