House Representative and Small Business Committee Chairman Steve Chabot, R-Ohio, announced late last week that he will cosponsor the Promotion and Expansion of Private Employee Ownership Bill of 2015 HR 2096 with the goal of “provide[ing] additional help for S corporations interested in forming employee stock ownership programs] (ESOPs)”. The bipartisan legislation is also sponsored by Representative David G. Reichert, R-Washington, and was originally introduced during the 111th Congress.
The bill includes provisions to encourage owners of S Corporations to sell their stock to an ESOP, expand financing opportunities for S Corporation ESOPs, provide technical assistance for companies that may be interested in forming an S Corporation ESOP, and ensure that small businesses that become ESOPs retain their Small Business Association certification.
Mr. Chabot noted, “S corporations have only been allowed to form ESOPs since 1998 and This structure works, and it works especially well for many small companies.”
Ranking member Nydia Velazquez, D-New York also spoke during the hearing about the benefits of ESOPs. “We should be doing more to enlighten employers and make it a more attractive retirement vehicle,” Velazquez said.
Numerous economic and tax benefits can evolve from proper use of an ESOP structure. These benefits are encompassed in significant potential tax savings, attractive alternative financing mechanisms and retirement security. The retirement security benefit is often most gained through the ability of employees to share in the wealth creation and growth of the companies that employ them.
“ESOP firms, including S ESOPs and C corporation ESOPs, have been shown to perform better than non-ESOPs by a number of metrics,” one witness testified. According to a 2000 study by Rutgers University, ESOP companies have greater longevity and up to 2.4-percent higher sales, employment and sales per employee annually, Brill noted. The study found that “productivity improves by an extra four to five percent on average in the year an ESOP is adopted, and the higher productivity level is maintained in subsequent years,” he added.
Employee commitment is seen as the driving force behind the increase in company performance and employee productivity lawmakers were told. It was further noted that a high degree of worker commitment and low rates of worker turnover are key components for small and medium-sized enterprises’ (SME) success in an increasingly competitive global marketplace.
The key changes proposed by the new legislation include the extension of the Internal Revenue Code section 1042(c)(1)(A), “the 1042 exclusion” to S corporations. Currently available only to sellers of C corporation stock, the exclusion allows deferral of any selling shareholder-level tax gains on the sale of shares to an ESOP so long as he or she reinvest the proceeds from the sale in “qualifying replacement securities”. The idea of deferring gain on the sale of the shareholder’s stock to an ESOP can go along way in moving the net economics to a favorable position for the seller. Without this legislation, S corporation shareholders have to “break” the S election to garner this benefit and then wait five years to reelect S status. Needless to say, such a strategy has proven less than popular with current S corporation owners.
The proposed bill also offers attractive incentives for lenders to get involved in facilitating a current S corporation shareholder to an ESOP. The enticements offered therein are intended to entice greater third party lender involvement in these types of transactions.
Finally, and perhaps most importantly, the bill promotes the creation of an S Corporation Employee Ownership Assistance Office within the Treasury. The new office is intended to foster increased employee ownership of S corporations.
Not part of the bill but indeed, current law, any S corporation income “pass through” to the ESOP that holds the shares is not subject to federal income tax and in many cases, escapes state income tax. This is a huge tax benefit for an S corporation owned by an ESOP, which this author has seen implemented to incredible operating results. One only need imagine a one-hundred (100) percent owned ESOP that was paying $300,000 to the Internal Revenue Service each year through its shareholder group. Post-ESOP adoption, the entire $300,000 is available for operational purposes.
There are a number of detailed tax considerations beyond the scope of this brief alert but suffice to say that the proposed legislation is very pro employee ownership.