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ESOP is Not a Fable

April 13, 2022

President Joe Biden’s proposed tax plan has created both an opportunity and some concerns about the prospective increase in capital gains tax and the impact on ESOP formation which is one of the key tax benefits to current sellers in the 1042 rollover. IRS Code Section 1042 is an elective provision that allows individuals, partnerships, trusts, and estates that sell shares of stock of a C-corporation to an ESOP to choose not to recognize the long-term capital gain realized in connection with the sale for federal income tax purposes by investing in eligible US securities. By doing so, the recognition of the capital gain is deferred until a future point in time. Under the code it is currently, the 1042 rollover allows the seller to defer tax on the sale of the company stock if the transaction closes as a C corporation if they invest in stocks and bonds. Then, at the time of an owner’s death, the estate has a stepped-up value that essentially eliminates capital gains.

Should this provision be eliminated, it would take away an ESOP transaction’s competitive advantage compared to a third-party purchaser. The Biden Administration has been viewing changes because of its acumen to have employees more empowered and participating in the growth and profitability of companies where they work. As of February 2021, the Secure Act extends the 1042 benefits to S corps owners and makes two ESOP incentives accessible in a single transaction. Companies can sell to an ESOP trust and become income-tax-free entities as 100% employee-owned S corps. At the same time, the selling shareholders can defer and potentially eliminate their capital gains burdens into the future.

The elimination of the stepped-up value at death could put a damper on ESOP transactions. While some pundits believe the elimination of the stepped-up value will decrease the incentives to form ESOPs, other authorities believe that, in an increased tax environment, any opportunity to defer taxes is a benefit. Further changes may take place since to goal of the Biden Administration is to be pro-labor and as well looks to disseminate corporate governance away from the hands of a few.

While a critical aspect of the proposed Biden tax plan is an increase in corporate taxes and since currently, ESOP contributions are tax-deductible, while there has been no suggestion that this status will change, expect there to be adjustments in favor of the ESOP participation qualities and the use of ESOP as a tool of corporate ownership since the use of pre-tax dollars in the ESOP transaction potentially creates a competitive advantage for ESOP-run companies.

Increased ESOP Formation May be the Wave of the Future

Studies show that employee-owned companies are more productive, grow faster, experience less employee turnover, and are more profitable than other companies. Because of these dynamics, it only makes sense that there will be an acceleration of ESOP activity. However, understanding the implication ESOPs have on the insurance market since the ESOP structure requires that the ESOP shares shall not be owned by employees, but rather, by an ESOP Trust formed and formulated in favor of the employees.

ESOP trustees have the following significant responsibilities:

Maintaining ERISA compliance of the plan based on the process agreement between the ESOP and the Department of Labor.

Monitoring the board of directors during the year and representing the best interest of all parties.

Performing due diligence for the transactions, including hiring the third-party appraiser for the fairness opinion and fair market value for the ESOP transaction.

Appointing the board of directors. If a company is 100% owned by an ESOP, the ESOP trustees have significant control of the board.

Remember, there will be a Board of Directors for an ESOP, separate and apart for the Board of Directors of the participating entity that has invited the use of an ESOP. Likewise, it therefore has similar obligations as all board of directors, including Duty of Care, Duty of Loyalty, and Duty of Obedience, yet, are separate, apart and unique in its perspective of these duties to protect those who are the participants in the ESOP.

However, differences in an ESOP structure create more exposure that may be subject to understanding ESOP laws, valuation and repurchase of stock, stricter consideration for executive pay, and balancing the needs of a founder if they still own a percentage and the beneficiaries of the ESOP. Therefore ESOP disclosures are crucial to helping employees understand the ESOP rollout, ESOP liquidity, and ESOP taxation that are part of good governance.

Prospective ESOP Issues Under the Biden Tax Plan

Expect the Biden Administration to initiate bold initiatives to empower ESOP participation for employees, so as to make it more efficient and manageable; even for smaller companies. Some macro-economic changes will be made. First, if there is an increase in ESOP transactions, there currently are not enough third-party trustees to support the growth. Secondly, consider in this difficult insurance market is that the number of insurers who are willing to underwrite both the ESOP transaction and the independent ESOP trustees has been reduced. Finally, the limits of liability the carriers are willing to provide is a challenge. However, this could create a new industry to empower ESOP participation, including an extension of the insurance from the instituting company of the ESOP to provide insurance protection since it will have an insurable interest.