By Corey Rosen and Loren Rodgers
On December 22, President Trump signed the tax reform bill, making its provisions the law of the land. The law’s accelerated timeline ensures that tax experts will uncover new implications of its many changes, especially to business taxation.
The tax reform bill’s most direct impact on broad-based employee ownership is through its provisions on certain broad-based equity compensation plans in private companies. The provisions do not apply to all forms of equity compensation, and they only affect private companies with broad-based plans, but employees of companies that meet the law’s requirements will find more favorable tax treatment of their plans.
The bill also affects ESOP companies, not directly through any changes to ESOP-specific laws but indirectly through some of its other provisions, such as the new limitations on how much interest expense is deductible, the new treatment of state and local taxes, the new rate for C corporations, and the 20 percent deduction on pass-through income.
Deductibility of Interest Expenses
The tax bill limits net interest deductions for businesses to 30 percent of EBITDA (earnings before interest, taxes, depreciation, and amortization) for four years, at which point the limit decreases to 30 percent of EBIT (not EBITDA). In other words, starting in 2022, businesses will subtract depreciation and amortization from their earnings before calculating their maximum deductible interest payments.
New leveraged ESOPs where the company borrows an amount that is large relative to its EBITDA may find that their deductible expenses will be lower and, therefore, their taxable income may be higher under this change. This change will not affect 100 percent ESOP-owned S corporations because they don't pay tax.
Many questions remain on the impact of this change. Importantly, it is not yet clear whether the limit on deductibility of interest will apply to loans made after the bill goes into effect or if it will apply retroactively. It is also unclear what impact the bill will have on alternative structures, such as replacing simple interest with warrants or payment-in-kind interest. People thinking about ESOP transactions should talk with their professional advisors about these issues and about restructuring the terms of their loans to better accommodate the deductibility limits.
Broad-Based Options and RSUs in Private Companies
The new tax bill contains a provision that will make it easier for employees of closely held companies who have illiquid stock options and restricted stock units to exercise the awards and not pay tax until a liquidity event occurs. The provision is a modified version of the Empowering Employee Ownership Act. Private companies that provide broad-based equity awards that are not liquid can now allow employees up to five years after termination of employment to sell their shares before paying taxes.
To qualify under the new rules, employees with stock options and restricted stock units could make an election to defer tax not less than 30 days before an award is fully vested or becomes transferable, even if they have left the company. They would not have to pay taxes until the earliest of the events listed below:
- The date when the shares are publicly traded
- The date that is five years after the first date the rights of the employee in such stock are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier.
- The date the employee revokes the special tax status of the award.
- The date on which the employee becomes an "excluded employee."
"Excluded employees" include one percent owners, CEOs and CFOs, and any of the top-four compensated employees at any time during the last 10 years. None of these can qualify for the deferral, and any employees who become excluded lose their preferential treatment. The equity grants must be available to 80 percent of the workforce. Rules for meeting the 80 percent test are similar to those for ESPPs. The election to defer tax would follow the same procedures now available for making a Section 83(b) election.
The new provisions would have limited applicability—most plans in private companies are not sufficiently broad-based to qualify, and many that use synthetic equity arrangements or restricted stock grants are not covered by this law, or provide vesting on liquidity.
The law is somewhat ambiguous as to when the taxation date occurs. Barbara Baksa of the National Association of Stock Plan Professionals believes that as it is written, it would calculate the income tax obligation as of the vesting date. So if shares vested at $50, but the employee exercised them when they were liquid five years later when they were $75, the employee would owe income tax on $50 and capital gains on $25. But if the shares dropped to $30, the employee still would owe tax on $50 and would also have a $20 capital loss. Others have said a more reasonable interpretation of what Congress intended is that the tax calculated would be exercised as ordinary income, but we will have to wait for regulations to clarify this.
Given the rules for this, companies may just opt to focus on incentive stock options (ISOs), which do not require tax until sale if certain criteria are met. But with ISOs, employees still have to come up with the funds to exercise the options, even though they cannot sell them yet, so this would work better for more highly paid people.
Corporate Taxes and Valuation
The tax reform bill reduces corporate income tax from 35 percent to 21 percent of corporate earnings, and the expected result is to increase the projected size of corporate after-tax profits. Those larger projections will, in turn, increase the appraised value of ESOP stock and, therefore, the size of ESOP companies’ repurchase obligation. In theory, this is not a problem for C corporations because they will presumably have more cash on hand to cover the repurchase obligation.
This change will also affect 100 percent ESOP-owned S corporations because their shares are appraised as if they were C corporation shares. Unlike C corporations, however, S corporations will not be generating any more cash than they had been before tax reform, so they will be facing a larger repurchase obligation without a corresponding increase in cash available.
State and Local Taxes
The bill imposes a cap of $10,000 on the amount of state and local income taxes that can be deducted from gross income. The resulting additional exposure to federal taxes could make it more appealing for sellers of businesses to use Section 1042, the provision allowing for deferral of federal taxation on the gains from the sale of stock to an ESOP (subject to meeting the requirements for such treatment).
If, for example, an owner in California sells $5 million in stock to a non-ESOP buyer, the seller would pay income tax on that with a top California marginal rate of 13.3 percent, resulting in up to $600,000 or more in state-level taxes, depending on factors such as the seller's filing status and how much is subject to the top state marginal rate. Under prior law, the state taxes would have been deducted from the seller's federal gross income, but the tax reform bill limits that deduction to $10,000.
Moreover, the $10,000 limit includes property taxes, which for many sellers in high-tax states will take up most or all of the $10,000, meaning that effectively little or none of the state tax on the ESOP sale will be deductible at the federal level.
In this example, the seller's federal taxable income will be up to $600,000 or so higher, subject to federal tax at a top marginal rate of 37 percent, increasing the combined federal and state tax rate by up to several points if the seller does not take the Section 1042 tax deferral by selling to an ESOP. This difference will be meaningful only in states with higher tax rates on capital gains, of course, and is unlikely to be a deciding issue, but it does add to the attractiveness of using the 1042 deferral.
S Corporation Deduction
The bill allows for owners of S corporations to deduct 20 percent of their income. So the sole owner of an S corporation that makes $1 million in income annually would have $1 million in taxable income in 2017, but she would have $800,000 after the tax law comes into effect in 2018. That reduces the comparative advantage of ESOP ownership over non-ESOP ownership of S corporations, but it may not be enough to change the calculation about being ESOP-owned or being a C or S corporation in all but a handful of cases.
The change would, however, reduce the required distributions of earnings to an ESOP in a less-than-100 percent ESOP-owned S corporation. S corporations must allocate distributions pro rata to earnings. Most S corporations make distributions to non-ESOP owners so they can pay their taxes on their share of corporate profits. So if an ESOP owns 30 percent of the company, it gets 30 percent of the distributions. These distributions now will be somewhat smaller because the non-ESOP owner will be declaring 20 percent less income and therefore requiring a smaller S distribution.
What Doesn't Change
These changes may affect the choices that companies make about equity compensation and ESOPs, but more important is what the tax reform bill does not change. We discussed the limited applicability of the equity compensation provisions above, and with regard to ESOPs, Section 1042 remains in place, ESOP trusts are still eligible owners of S corporation shares, and other tax incentives for employee ownership are unchanged.
Some possible changes in non-ESOP law that would have had an impact on ESOPs were also not part of the final tax reform bill. Tax rates on capital gains are unchanged, as is the 3.8 percent "Obamacare" Medicare surtax (which applies to the lesser of net investment income and modified adjusted gross income above $200,000 for individuals and $250,000 for joint filers). In addition, the 0.9 percent Medicare surtax on earned income and the tax on qualified dividends remain in place.
Members: Contact Us with Your Ideas, Concerns, and Solutions
The National Center for Employee Ownership (NCEO) invite all members to contribute their ideas, concerns, and potential solutions. Please contact Executive Director Loren Rodgers (LRodgers@nceo.org) and NCEO Founder Corey Rosen (CRosen@nceo.org).
More information on the effects of tax reform on employee ownership will be covered in sessions at our annual conference (Atlanta, April 18-20, 2018, with preconference sessions on April 17).
Corey Rosen, founder, NCEO
Loren Rodgers, executive director, NCEO