By Otto Lange
Recent legislation submitted by U.S. Congressman Dave Reichert (WA-8) could dramatically improve the legislative and tax environment for employee stock ownership plans (ESOPs). If passed, H.R. Bill 2092: Promotion and Expansion of Private Employee Ownership Act of 2017 will help small businesses meet Small Business Administration (SBA) certification requirements, allow selling business owners to elect Internal Revenue Code (IRC) Section 1042 for stock sales in any domestic corporation—not just C corporations, and interest paid on bank loans to finance ESOP transactions will be deductible expenses.
Improved SBA Regulations of ESOPs in the U.S.
Under the SBA regulations defined by the Small Business Act of 1958, businesses that apply for 8(a) business development programs must be owned and managed by qualified shareholders who directly own 51 percent of all outstanding shares in their company, as well as 51 percent of each class of share. This 51 percent ownership calculation excludes indirect ownership through an ESOP. For more information, please read my other article on how this requirement affected Precise Systems, Inc.
The exclusion of ownership through an ESOP has restricted small businesses to only allocating 49 percent of their shares to an ESOP if they intend to keep their SBA certifications. Although the U.S. government has historically encouraged ESOP expansion, this SBA requirement has acted like a penalty for having too many shares allocated to employees through an ESOP.
H.R. 2092 will not lower the 51 percent threshold to meet SBA certification calculations, but would require the SBA to include indirect ownership through an ESOP for calculation purposes. As an example, this means that if 51 percent of all shares outstanding are allocated to women directly or indirectly through an ESOP, a woman-owned small business (WOSB) would be able to keep its certification. H.R. 2092 would allow a WOSB to be 100 percent ESOP-owned and still meet SBA requirements for WOSB certification. Having an ESOP hold more than 49 percent of outstanding shares would not preclude a company from keeping their SBA certification(s).
Establishment of the "S Corporation Employee Ownership Assistance Office"
Because ESOPs are classified as tax-free entities by the U.S. government, the optimal business arrangement is for an ESOP-company to be registered as an S Corporation. S Corporations pass-through income to their shareholders (i.e. the ESOP), and the shareholders are responsible for the income taxes. This means that S Corporations that are 100 percent-owned by an ESOP essentially operate as tax-free entities.
To promote this arrangement, H.R. 2092 wants the U.S. Government to continue helping S Corporations establish ESOPs. The bill calls for the Department of the Treasury to establish the “S Corporation Employee Ownership Assistance Office” to assist business owners with the educational and legal aspects of establishing an ESOP. The Department of the Treasury would be able to provide technical assistance drafting ESOP documents, allocating shares to employees, and engaging ESOP companies in the U.S. The “S Corporation Employee Ownership Assistance Office” will allow the U.S. government to take a more active role in promoting employee ownership in the U.S.
Preferential Tax Treatment to Companies Establishing an ESOP
One of the biggest benefits to establishing an ESOP is for selling shareholders to defer taxation on their earnings under IRC Section 1042. Shareholders that sell their shares to an ESOP are eligible to elect Section 1042, and may defer taxation indefinitely on their proceeds. One restriction, however, is that the company must be registered as a C Corporation at the time of sale.
This has proven to be a cumbersome restriction for many business owners, and has deterred countless companies from electing 1042. S Corporations have the option of switching to a C Corporation for their selling shareholders to elect 1042, but this also subjects the corporation to an arbitrary five-year waiting period before being able to reregister as an S Corporation. This waiting period has led many selling shareholders to forgo the tax benefits of Section 1042, and avoid placing any undue hardship on their company post-transaction.
H.R. 2092 will redefine Section 1042 eligibility from “C Corporation” to “Domestic Corporation.” This means that shareholders selling shares to an ESOP in any U.S.-based corporation would be eligible to elect 1042. S Corporation will therefore not need to switch to a C Corporation, and selling shareholders will be eligible for tax deferrals under 1042. This will reduce the company’s cost of establishing an ESOP, and increase the benefits to selling shareholders. A win-win for any company considering an ESOP.
Companies Could Deduct Up to 50 Percent of Interest Payments on Leveraged Transactions
H.R. 2092 seeks to further reduce the costs of establishing an ESOP by allowing interest payments to be deductible expenses. One unique characteristic of ESOPs is that ESOPs can be leveraged to finance equity transactions. Companies that sell more than 50 percent of their outstanding shares to an ESOP would be eligible to deduct interest paid on bank loans to finance the transaction. Companies that leverage their ESOPs for a majority ownership stake could deduct up to 50 percent of the interest paid on the bank loans.
The benefits of this section are two-fold. First, companies benefit by being able to deduct interest expenses; thereby reducing the costs of establishing an ESOP. Second, having the ESOP become the majority shareholder promotes employee ownership by allowing more employees to become owners, and provides each employee with a greater share of the company’s success. This, in turn, will further increase the benefits recognized by the company as employees are better invested and more engaged in the company’s success.
H.R. 2092’s Path through Congress
Congressman Dave Reichert has been working on this bill with lobby group ESCA, Employee-Owned S Corporations of America, since at least 2011. This bill has previously been submitted in 2011, 2014, 2015, and H.R. 2092 (2017) is the fourth attempt at getting this legislation approved. Identical legislation has also been submitted in the Senate by Senator Benjamin Cardin (D-Md.) in 2011, 2013, and 2015 and will likely be introduced again in the next few months.
Each attempt at passing this legislation has ended at the introduction phase. The bill in the Senate has been referred to the Senate Finance Committee three times and has not progressed. The bill in the House of Representatives has been introduced to the House Ways and Means Committee four times and has also not progressed.
Despite the bills not moving through committee, there has been widespread, bipartisan support for the legislation. At least 129 Legislators (24 percent of Congress) from both sides of the aisle have expressed support for the bills and have agreed to be cosponsors. This widespread appeal is a strong sign the bill could be approved in the future.
While it is not immediately clear that H.R. 2092: Promotion and Expansion of Private Employee Ownership Act of 2017 will be passed this year or next, it is apparent there is a desire to improve the ESOP regulatory environment. The government can and should do more to promote employee ownership, and this bill would fix a lot of problems caused by overlapping government agencies with counterproductive—even contradictory—requirements.
What You Can Do:
If you feel strongly that this bill is something that would improve the ESOP community, and you would like this legislation to be passed, you can search for your Congressional representative at this link: Find Your Representative
Calling your Congressional representative and expressing support for the bill would increase the probability that H.R. 2092 will move through the committee. This is especially true if your representative is a member of the House Ways and Means Committee.
You may read H.R. Bill 2092, and track its progress through the House of Representatives here: H.R. Bill 2092
Otto Lange, graduate student associate, Beyster Institute and Rady MBA candidate 2018