Maximizing ESOP Tax Benefits
under the New Tax Law
Significant or even “massive” tax reform is on the horizon for 2017.
Retroactive tax changes are very rare, the last one occurring under the Clinton Administration. If the “stars align”, it is conceivable that tax reform could be retroactively effective as of January 1, 2017. A much more likely scenario is that a tax bill will be reported out of the Ways and Means Committee in the first or second quarter of 2017. The date that the bill is reported out is normally the initial effective date, for example April 1, 2017. The final effective date of the new legislation is frequently on or near the date of enactment, for example July 1, 2017. Although, it could be later.
Are ESOPs “Safe”?
With Republicans in control of the House of Representatives, many assume that ESOPs are “safe.” Paul Ryan, the Speaker of the House, is a long-time ardent ESOP supporter, as is Bob Goodlatte, Chair of the powerful Judiciary Committee. There are a number of other senior Republicans who have been staunch ESOP supporters for many years. The flaw in that argument is that the final version of the tax bill will not be what is passed by the House of Representatives, nor by the Senate, but what comes out of the resulting House-Senate Conference Committee. This Conference Committee is charged with reconciling the differences in the Senate and House versions of a tax bill. There are numerous examples of provisions coming out of the “all-nighter” Conference Committee meeting that bear little resemblance to what either House or Senate passed. ESOP tax provisions are no exception.
ESOPs always have been, and continue to be, bipartisan. There are currently over 40 Senators and 120 Representatives both Republican and Democrat, supporting current pro ESOP legislation including S. 1212 and H. R. 2096. That bipartisan support bodes well for maintaining and maybe even expanding ESOP benefits.
Don’t Wait to Explore
There are certain things you don’t wait for (like a tarantula continuing to crawl on you – see the movie “Home Alone”). When it comes to ESOP transactions in 2017, waiting will be very unlikely to achieve any additional tax savings, and in fact under certain circumstances waiting would result in losing tax benefits.
The experts tell us that tax rates for C corporations will be lowered in the new tax bill. However, any tax deductions made to an ESOP sponsored by a C corporation will be deductible at the old higher rate until the new rates take effect. (There is serious discussion of a reduction of 10% to 15% of the top C corporation tax rates.)
Additional Deductions for 2016?
For existing ESOPs, the deadline for a tax deductible ESOP contribution is the filing of the C corporation tax return, including extensions. There are a variety of reasons that boards of directors of C corporations should consider an additional contribution for 2016 including prefunding repurchase obligation and “warehousing” cash for a future ESOP transaction.
ESOP “Tax-free” Rollover
Under IRC Section 1042, eligible individuals can sell stock to a C corporation ESOP and under certain conditions pay no capital gains tax. Under current tax law, the deferral can be permanent. While it is widely assumed that the Federal capital gains rate will be reduced, states like California and New York still have state rates near 10% or more and most states are at least at 5%.
If the federal capital gains rate is reduced to 15%, the “tax free” rollover still means a savings of 20% to 25% for tax payers in most states. So you really can “have your cake and eat it too”. IRC 1042 allows the selling shareholder 12 months from the date of the sale to the ESOP to purchase Qualified Replacement Property (QRP), stocks and bonds of US corporations, to qualify. Practically speaking the decision in many cases needs to be made by the filing of the individual’s tax return.
“Having Your Cake” C Corporation Example:
An ESOP sponsored by a C corporation acquires a 30% or greater block of stock on July 1, 2017. The individuals who sold to the ESOP have for all practical purposes until April 15, 2018 to decide to elect the “tax-free” rollover for all, part, or none of the transaction. The latest anticipated effective date for the lower capital gains rate is January 1, 2018.
Like C corporations referenced above, S corporations also have until the filing of the corporate tax return, including extensions, to make a tax deductible contribution for 2016. A larger tax deductible contribution to the ESOP for 2016 means a reduced amount of taxable income for non ESOP S corporation shareholders.
Lower Tax Rates for S Corporation Sellers
Individuals who sell stock to an ESOP sponsored by an S corporation are not eligible to elect the IRC 1042 “tax-free” rollover. If the game plan would be to do an ESOP transaction by June 30, 2017, the ESOP transaction can proceed and still give the sellers the ability to pay capital gains taxes at the new lower rate when effective. By closing the ESOP transaction on June 30, the S corporation would have tax-free income for the second half of the year.
“Having your Cake” S Corporation Example:
As the date approaches, it becomes clear that the new tax rates will not be effective until the second half of 2017 at the earliest, and perhaps January 1, 2018. The seller(s) at closing can take back a low rate, interest only, note for the second half of 2017. The seller notes could be refinanced in early January of 2018 with senior bank debt and/or subordinated mezzanine debt. The cash proceeds would be taxable at the capital gains rate in effect in 2018.
An Informed DecisionThe take aways from this very brief analysis are:
- If you were considering or starting to look at an ESOP transaction in 2017, keep looking. It may turn out for non-tax reasons that the timing isn’t right for an ESOP transaction, but don’t put it on the shelf because you anticipate that tax rates will be decreasing.
- Existing ESOP companies should take a hard look at larger than usual ESOP contributions that will be deductible in 2016.