ESOP services legislative updates

Pension Protection Act of 2006

The Cost Accounting Standards Board (CASB) issued a final ruling in May 2008 that applies to federal government contractors who sponsor ESOPs. The effective date of 48 CFR Part 9904 was June 2, 2008. It amends CAS 412 and 415.

At the heart of the matter is the “allowable cost” that federal government contractors may claim for contributions or dividends paid to an ESOP. The CASB ruling states that the “contractor’s cost shall be measured by the contractor’s contribution, including interest and dividends if applicable, to the ESOP”. The CASB did not use the GAAP approach in SOP 93-6, which measures compensation expense for a leveraged ESOP based on the fair-market value of shares released in a year. Under certain types of federal government contracts, the company is reimbursed by the federal government for the ESOP contribution. Both cash and stock contributions are allowable costs, and thus are reimbursable. There is no distinction between S Corporation and C Corporation ESOPs.

While the CASB ruling quoted above specifically includes dividends, The ESOP Association has learned that at least one DCAA regional office has disallowed dividends as an allowable cost. In doing so, they site Federal Acquisition Regulation (FAR) 31-205-6(i)(2), which disallows “any compensation represented by dividend payments or which is calculated based on dividend payments”.

The dividend payments that were disallowed were made before the effective date of June 2^nd. The ruling came after June 2^nd. One might assume that contributions or dividends made to an ESOP after June 2^nd would be subject to CASB ruling. However, CASB rulings deal with allocation and measure of costs, and the FAR deals with allowability. The disallowance made reference to this distinction and to language in the CASB ruling that says, “The board further notes whether interest or other cost components associated with financing a leveraged ESOP are allowable cost is determined under FAR 31. The final rule does not in any manner preclude the FAR counsel from drafting rules that explicitly allow or disallow interest or any other cost component associated with an ESOP.”

The CASB ruling gives a number of examples to clarify the ruling, recognizing that not only the timing of the contribution but also the timing of the ESOP allocation that results from the contribution determines if the contribution will be an allowable cost. This is consistent with IRS rules for ESOPs. Unfortunately, none of the examples mention dividends.

As a result, federal government contractors would be WELL ADVISED to consult with their professional advisors, and possibly their local DCAA office, if they are planning to claim dividends as an allowable cost.

With exception of the dividend issue, federal government contractors now have the greatest degree of certainty that they have ever had regarding the treatment of ESOPs contributions as an allowable cost.

Keep in mind that ESOP stock valuations remain subject to DCAA audit. Should the DCAA determine that ESOP shares were over valued, the DCAA could attempt to disallow a portion of an ESOP contribution.

Good News for Government Contractor ESOP Companies:
ESOP Contributions Are Reimbursable Expenses

For many years, there have been questions regarding the inclusion of ESOP expenses as reimbursable costs for ESOP government contractors and that have cost-plus contracts. The U.S. Cost Accounting Standards Board issued final rules on May 1, 2008, clarifying the treatment of ESOP expenses in a manner that is very favorable to ESOP companies.

The questions that have existed for years are (1) the measurement of expenses for non-leveraged and leveraged ESOPs; (2) whether a contributions for interest on the ESOP note were reimbursable; (3) whether dividends paid to an ESOP that are deductible for federal income tax purposes would be a reimbursable expense; and (4) whether the contractor's reimbursable expense should be measure in a manner similar to Statement of Accounting Position 93-6.

ESOP companies engaging in cost-plus contracts with the government were at a huge disadvantage because of uncertainties regarding their ability to be reimbursed for their ESOP expenses.

Those uncertainties have now been removed. All of those questions have been answered favorably for ESOPs.

The Cost Accounting Standards Board ruled that: (1) company ESOP contributions are reimbursable whether made in cash or stock ; (2) contributions made for both principal and interest on ESOP notes are reimbursable; (3) cash dividends paid on stock owned by the ESOP are reimbursable to the extent the dividends are used to make a payment on an ESOP note; and (4) expenses are measured by the cash or fair market value of the stock contributed, and not by the value of shares released method of SOP 93-6. There was no distinction in the rules between C and S Corp ESOPs.

The removal of the uncertainties and the favorable rules re ESOPs may encourage non-ESOP government contractors to establish ESOPs and may encourage ESOP companies who had previously avoided cost-plus contracts to seek them out in the future.

ESOP companies performing cost-plus contracts for the government should consult with their professional advisors to assess the impact of these new rules on their specific situation.

The ESOP Association Applauds Introduction of Resolution Supporting Employee Ownership through ESOPs by Congressmen Maurice Hinchey and Dana Rohrabacher

Congressmen Maurice Hinchey (D-NY) and Dana Rohrabacher (R-CA) introduced on April 24, 2008 House Concurrent Resolution 333, which expresses continued support for employee stock ownership plans (ESOPs) in the U.S.

J. Michael Keeling, President of The ESOP Association, had this to say about the Resolution: I welcome the bi-partisan efforts of Congressman Maurice Hinchey (D-NY) and Congressman Dana Rohrabacher (R-CA). The leadership of these House senior members to reiterate the thirty plus years of support for employee ownership through ESOPs is important. Clearly change is in the wind but a commitment by Congress to a fair and more equitable form of ownership is as important in the 21st century as in the 20th. On behalf of the 2,500 plus members of The ESOP Association, I urge all members of Congress to co-sponsor this resolution. Research has consistently shown that employee owned companies are high performing, have better sales, and provide more retirement savings compared to their non-ESOP counterparts.

To view a copy of House Concurrent Resolution 333, please visit http://thomas.loc.gov/. Then enter H.CON.RES.333 in the Search Bill Text box and also check the bullet circle by the "Bill Number".

House Ways and Means Committee Proposes Cutback in outside equity incentives
(Stock options, Stock Appreciation Rights (SARs), Warrants, Phantom Stock, etc.)

Legislation introduced 10/25/07 by Chair of the House Ways and Means Committee, Charles Rangel [D-NY], has as a so-called loophole closer, a provision that impacts an S ESOP corporation’s granting equity incentives to employees by assessing additional taxes that could exceed 100%.

Section 3701 of HR 3970, refers to a stock "option", but defines as an “option” any interest that is the same as what is defined as synthetic equity in IRC 409(p)(6)(C) and would apply to options granted after the date of enactment.

The legislation will supposedly raise $600 million over ten years, or $60 million per year, in order to help pay for a near $400 billion reduction in corporate income taxes due to a proposed rate cut in the C corporation current rate of 35% to 30.5%, a proposal initiated by the Administration.

(The proposal does not impact the underlying tax treatment of the S corporation’s taxable income pro rated to the ESOP’s ownership share.)

“The ESOP Association’s historical posture is to be aggressive in protecting ESOP law and ESOP companies, as one set back often emboldens ESOP cynics to seek more ESOP cutbacks later,” said ESOP Association President and Chief Staff Officer Michael Keeling. “As noted when the Treasury Department recommended doing away with all ESOP tax benefits to pay for a corporate rate reduction in the name of making America more competitive, it is ludicrous to cut back on a program—employee ownership through ESOPs—that has proven to more often than not create a high performing, competitive company that is fair to employees. On the other hand, we are pleased that the Democratic leadership of Ways and Means did not endorse the more anti-ESOP proposal embedded in the Treasury Department recommendation in August.”

There is strong opposition to the entire bill, and enactment would be no earlier than some time in 2008, or perhaps even later, if ever. The provision is summarized below.

You can read this provision and the entire bill by going on the Ways and Means web site, and clicking on the left hand side, under Hot Topics, the live connection to the language of HR 3970, which is labeled as "HR 3970, The Tax Reduction and Reform Act of 2007." The Ways and Means site can be accessed http://waysandmeans.house.gov/MoreInfo.asp?section=34

Explanation of "Employee stock Ownership Plan Promotion and Improvement Act of 2007

These provisions are included in the 2007 pro-ESOP legislation S. 1322 in 2007. When new pro-ESOP legislation is introduced in the House of Representatives, it is anticipated that the House legislation will include provisions such as those in S. 1322, as set forth below.

The Future of ESOPs

by Ronald J. Gilbert, ESOP Services, Inc.

November 2006

What will the new Democrat-controlled Congress mean for the future of ESOPs? Optimists would argue that ESOPs have always been bipartisan. Senator Russell Long, Democrat of Louisiana, was the legislative father of the ESOP, and the sponsor of the current pro-ESOP bill in the Senate is Democrat Blanch Lincoln of Arkansas. There are also several Democrat co-sponsors of the House version of the same bill, and Senator John Breaux, Democrat of Louisiana was an ESOP champion until his retirement two years ago.

Pessimists would argue that the strongest support for ESOPs in the House of Representatives for quite a few years has come from Republicans and that in the past two years we have lost several ESOP champions due to retirement or election, including Representatives Cass Ballenger and Nancy Johnson, and Senator George Allen.

In our opinion, it is too early to be optimistic or pessimistic, but it is not too early to be concerned, practical, and to take action.

Concerned

The Treasury Department is expected to make its recommendations regarding tax reform to the Congress in 2007. For over a year, they have been reviewing recommendations on tax reform made by a Presidential Commission, which recommended among other things eliminating all defined contribution retirement plans. ESOPs are a type of defined contribution plan. See “Eliminate All ESOPs?”

The incoming chairman of the House Ways and Means Committee, Charles Rangel, has stated that he will “work with the President on tax reform”. Anytime broad-base tax reform is considered, it should be a cause of concern for ESOP supporters. It should be more of a cause of concern because the Treasury Department has refused to provide ESOP advocates any comfort that their recommendations will protect ESOPs. Maybe they will or maybe they will not; we just do not know. Even if ESOPs are not a specific target for elimination, they could be caught up in the congressional need to “pay” for additional tax cuts. In order words, the House Ways and Means Committee and/or the Senate Finance Committee may decide that there needs to be a cut-back to certain ESOP benefits in order to make room for other tax incentives.

What Might Get Cut Back?

Tax-free S Corporation income could certainly become a target as it is the “new kid on the block,” becoming effective in 1998.

Practical Considerations

If you are concerned, and you should be, what can you do? If you are considering implementing an ESOP, or if you have an existing ESOP that contemplates acquiring additional stock, take a close, hard look at doing it very soon. The effective date of a tax bill, assuming it passes both the House and Senate and is signed by the President, is frequently the day it is reported out of the House Ways and Means Committee. In theory, this could occur anytime after Congress convenes in January 2007. Practically speaking, March would seem to be the earliest possible date.

Will ESOP Provisions Be Grand fathered?

Over the past thirty-two years, ESOP tax benefits have been reduced or eliminated on several occasions, and in those instances what was in place was grand fathered. While this history of grand fathered ESOP tax benefits is no guarantee, we believe there is a high probability that any existing ESOP structure would be grand fathered. For example, if the ESOP S Corporation tax-free benefit was eliminated or reduced, the percentage of stock owned by the ESOP prior to the effective date of the new legislation would continue to be free from federal income tax under a grandfather provision.

Action Required

For those companies contemplating an ESOP transaction, whether it be a new ESOP or an increase of ownership in an existing ESOP, the time to study the matter very carefully is now.

LEGISLATIVE UPDATES

Summary: The 907 page law primarily deals with defined benefit plan law; however a few provisions will impact sponsors of ESOPs. President Bush has signed the act into law August 17, 2006.

Changes pertaining to ESOPS:

Sec. 811. Pensions and individual retirement arrangement provisions of Economic

Growth and Tax Relief Reconciliation Act of 2001 made permanent.

Positive laws for defined contribution plans (including ESOPs) were enacted as temporary measures in Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) which substantially increased pension and individual retirement account (IRA) contribution limits through 2010. These provisions are made permanent; the amount that can be added to an employee's defined contribution retirement plan annually is the lesser of 100% of eligible pay or $44,000 (in 2006, indexed annually).

Sec. 904. Faster vesting of employer non elective contributions

Minimum vesting requirements for ESOPs and non-contributory stock bonus plans (ESOPS are a stock bonus plan) become three year cliff or six year graded compared to five year cliff or seven year graded, except ESOPs with a outstanding securities acquisition loan may use five or seven schedule until the loan is paid. Existing ESOPs that are repaying a loan in place as of September 26, 2005, however, would not be subject to these rules for shares acquired by the loan for any plan year beginning on the earlier of the date the loan is fully repaid or the date on which the loan was scheduled to be repaid as of September 26, 2005. The new rule takes effect for contributions made after December 31, 2006

According to Corey Rosen, the executive Director of the National Center for Employee Ownership, addressing the vesting change, “ESOP companies really should not lose any sleep over this change….Very few companies of any kind, but especially companies with already low turnover, have more than a tiny percentage of the workforce leaving in years four or five (for cliff vesting) or year seven. Employees who work for three years generally work for many more. The impact is so small, in fact that most companies will want to apply the new rules to all contributions.”

SEC. 622. Increase maximum bond amount

For plan years beginning after December 31, 2007, trustee bond requirements are increased from $500,000 to
$1,000,000.

SEC. 901. DEFINED CONTRIBUTION PLANS REQUIRED TO PROVIDE EMPLOYEES WITH FREEDOM TO INVEST THEIR PLAN ASSETS.

Public company K-SOPs must offer diversification of company stock after three years.

Actions to take:

Companies should consult with counsel regarding updating existing plans.

Complete text of H.R. 4 Pension Protection Act of 2006 and Pension Reform

available at Committee on Ways and Means.

New Virginia Law Allows 100% ESOP Ownership
of Certain Professional Corporations

On March 8th, the Virginia General Assembly passed a bill allowing some professional corporations to be up to 100% ESOP owned under certain conditions. It will effective July 1, 2006. The bill is awaiting the Governor’s signature, which is expected.

The bill, HB 952 “Professional Corporations; Employee Stock Ownership Plans”, was sponsored in the Senate by Senator Walter Stosch, the Republican Majority Leader. The bill was sponsored in the House by Delegate Joannou, a Democrat. (A thirty-plus-year track record of bipartisan support for ESOP legislation continues!) Senator Stosch’s and Delegate Joannou’s motivation was to allow professional corporations the option to be perpetuated through the use of an ESOP. Prior to this law being passed, they were oftentimes forced to sell to out-of-state entities when key professional owners decided to retire, according to Ron Gilbert, President of ESOP Services, Inc, who worked with Senator Stosch in drafting the legislation.

Accounting, architectural, engineering, land surveyors and other professional corporations can be up to 100% ESOP owned, provided that the following conditions are met.

The required minimum percentage ownership by professionals must be maintained using IRC 409p inside the ESOP as the criteria. Majority ownership is required for accounting firms in Virginia, two-thirds ownership by the other professional corporations covered under this bill.

The trustees of the ESOP must be licensed professionals (the Board of Directors may appoint an independent trustee or fiduciary if a conflict of interest situation arises).

Stock will not be distributed to non-licensed professional, with an “immediate buy-back” exception.

This bill will hopefully serve as a model for other states who wish to give their professional corporations an option of remaining independent.

The Presidential Advisory Panel of Federal Tax Reform released its report on November 1, 2005. The report recommends eliminating all defined contribution plans and combining all 401(k) type plans (403(b), etc.) into one “save at work” plan. The ESOP is a defined contribution plan. On the face of it, the report recommends killing ESOPs. Could this really be? The report specifically states that defined benefit plans will be untouched. The report could have put ESOPs in the same category, but it did not. The report also has negative things to say about stock option plans. While the ESOP is extremely different from a stock option plan, could the members of the commission have failed to make a distinction? That is very doubtful with former Senator John Breaux serving as Vice Chair of the Commission. Senator Breaux championed ESOP legislation throughout his senate career and spoke movingly at the funeral of Senator Russell Long, the “legislative father of the ESOP,” regarding Senator Long’s legacy.

Perhaps the commission meant to eliminate just the employee contributory defined contribution plans like 401(k) and 403(b), but not company funded plans such as profit sharing plans and ESOPs. However, there is nothing in the report to suggest that this is the case.

Until a senior official from the White House, or the Treasury Department, tells us otherwise, we must assume the worst, that the report means exactly what it says – “eliminate all defined contribution plans.” Our hope is that sooner rather than later, we will get a clarification that ESOPs are protected just like defined benefits plans. If that assurance is not forthcoming, there may well be much boarder, negative implications for broad-based employee ownership.

There has been little said in recent months by the President about the ownership society. This is understandable given the many other issues being dealt with by the Bush administration. This does not in and of itself signal any lessening of the President’s strong support for an ownership society. However, failure to protect ESOPs at the very beginning of the tax reform policy will certainly send a strong signal that the ownership society is no longer an important priority. How else could the elimination of the ESOP, the only plan with a thirty year track record of broadening employee ownership, be interpreted? How else could the elimination of the S Corporation ESOP, which now constitutes the majority of ESOPs in privately held companies, be interpreted? How else could the elimination of an entrepreneurial small business benefit (approximately 90% of ESOPs are in companies of fewer than 500 employees) be interpreted? How else could the elimination of the program that Ronald Reagan strongly supported before he was President, while he was President, and after he left the Presidency be interpreted?

The Presidential Tax Commission’s recommendations are currently just that, “recommendations.” It will probably be 2007 before the appropriate committees in the House and Senate take up hearings on these recommendations.

The ESOP can and should serve as the foundation of the ownership society, which President Bush so eloquently spoke about in his second inaugural address; “To give every American a stake in the promise and future of our country, we will bring high standards to our schools, and build an ownership society. We will widen the ownership of homes and businesses, retirement savings and health insurance – preparing our people for the challenges of life in a free society. By making every citizen an agent of his or her own destiny, we will give our fellow Americans greater freedom from want and fear, and make our society more prosperous and just and equal.”

Senator George Allen (R-VA) has co-sponsored the pro-ESOP bill recently introduced by Senator Blanche Lincoln ("D-AR") S1319. Congressmen Cantor ("R-VA") and Goode ("R-VA") have co-sponsored the companion bill introduced by Representative Nancy Johnson ("R-CT") H.R.3111.

The three Virginians have been strong supporters of ESOPs, and all three co-sponsored a similar bill in the previous session of Congress.

The primary features of the bill would repeal the punitive 10% penalty tax on S Corporation dividends paid to employee owners (employees pay ordinary income tax when the cash dividends are received). Passage of this provision would cause many S Corporation ESOPs to pay cash dividends to their employees. The bill also permits sellers of stock to a S Corporation ESOP to elect the tax-deferred rollover under IRC1042. Stockholders in C Corporations have had this option available for over twenty years.

Those Interested in Employee Ownership Through ESOPs Should
Speak Out for Proposed Pro-ESOP Legislation

Congress is moving to implement various aspects of President Bush’s call for building an ownership society. It is very important that the ESOP community makes a strong, pro-ESOP offense, and in doing so, makes a case that ESOPs should be an integral part of any set of policies to develop an ownership society. The provisions of H.R. 3111 and S. 1319 will be beneficial to many current sponsors of ESOPs, and lead to more ESOPs, which will strengthen the voice of ESOPs in the national debate over an ownership society.

Congressional allies of employee ownership through ESOPs have introduced the ESOP Promotion and Improvement Act of 2005 in both the Senate and the House. The primary sponsor in the Senate is Senator Blanche L. Lincoln (D-AR) and the primary sponsor in the House is Representative Nancy L. Johnson (R-CT). Mrs. Johnson was joined by Representatives Jim McCrey (R-LA) and William J. Jefferson (D-LA).

Section 1: Titles the bill the Employee Stock Ownership Plan and Improvement Act of 2005.

Section 2: Repeals the punitive 10% penalty tax on S corporations of distributions from current earnings, also referred to as dividends, paid on ESOP stock that are passed through to ESOP participants in cash.

Section 3: Clarifies that dividends paid by C corporations on ESOP stock are not a preference item in calculating the corporate alternative minimum tax.

Section 4: (a) Permits sellers of stock to the ESOP of an S corporation to utilize the ESOP tax benefit referred to as the tax deferred rollover, or the 1042 treatment. (b) Permits proceeds received from a 1042 transaction to be invested in mutual funds consisting of operating US corporation securities. (c) Redefines who is a 25% or more owner for purposes of IRC 1042 to be 25% or more ownership of voting stock, or 25% or more ownership of all stock of the corporation, not 25% of any class of stock.

Section 5: Permits early withdrawals from ESOPs, as with other ERISA plans, for first time home purchase or payment of college tuition, with various restrictions. The withdrawal may not be more than 10% of account balance, and the individual has had to have participated for five years in the ESOP.

Section 6: Increase the de minimums amount exempt from mandatory ESOP diversification requirements from ESOP balances from $500 to $2,500 per account.

The Association’s President, J. Michael Keeling, urges all advocates of ESOPs to write their Member of Congress and ask for support of this pro-ESOP legislation.

More information is available on H.R. 3111 and S. 1319 on The ESOP Association web site at: www.esopassociation.org-.html.

Section 2: Under current law since 1984, when a C corporation pays dividends on an employee’s stock in an ESOP, and the employee receives the dividends in cash, the employee pays regular income tax on the dividends; but if the employee works for an S corporation that sponsors an ESOP, and the employee owner receives a “dividend” on ESOP stock, the employee owner will pay regular tax plus a 10% penalty tax. Section 2 eliminates the 10% penalty tax on the employee owner’s dividends received on ESOP stock paid by an S corporation. There is ample legislative history that Congress in enacting the 1997 law permitting S corporations to sponsor ESOPs never intended to impose a penalty tax on dividends paid to employee owners.

Section 3: The IRS interprets a 1989 law as imposing the corporate alternative minimum tax on dividends paid on ESOP stock. There is little legislative history to support the view that Congress wanted to discourage the paying of dividends to employee owners participating in an ESOP. Section 3 clarifies that the 1989 corporate AMT law did not sanction taxing ESOP dividends.

Section 4(a): Current law since 1984 permits the owner of privately-held C corporation stock sold to an ESOP to defer his or her capital gains tax if after the sale the ESOP owns at least 30% of the C corporation, and the seller reinvests the proceeds in another U.S. operating corporation; but the 1997 law permitting S corporations to sponsor ESOPs does not provide this opportunity for owners of S corporation stock. Section 4(a) conforms the S ESOP law to the C ESOP law. (Data indicates that approximately 75% of the ESOP companies created in

America

were incentivised by this provision of law, known as the ESOP tax deferred rollover law.)

Section 4(b): The 1984 law referenced above was enacted before the boom in mutual funds, and does not permit the proceeds of the seller to be reinvested in mutual funds. Section 4(b) would modernize the 1984 law by permitting the proceeds from the sale to the ESOP to be reinvested in mutual funds consisting of securities of

U.S.

operating companies.

Section 4(c): Clarifies that anyone who owns 25% or more of the voting stock, or 25% or more of the value, of an ESOP company, cannot participate in the ESOP with stock sold to the ESOP utilizing the provision described in Section 4(a). Current law oddly prohibits the 25% or more owner of any class of stock from participation

Section 5: Current law permits a participant in a 401(k) plan to withdraw from an account limited amounts to help purchase a first home, or pay college tuition, without paying a 10% penalty tax on the withdrawn amount. Section 5 permits an ESOP to offer participants the same option.

Section 6: Current law, since 1986, imposes mandatory diversification rules on ESOP accounts for certain employees if an account balance is over $500. The $500 is not indexed for inflation, and has never been adjusted since 1987. Section 6 raises the $500 to $2,500 in order to ease one of the administrative burdens on ESOP sponsors.

Revenue Impact: While there is no formal revenue estimate on H.R. 3111/S. 1319 at this time, its revenue impact should be reasonable, as all sections amend existing law on which there are years of revenue expenditure data. None of the data on these existing ESOP laws have evidenced large revenue losses. In fact, Section 2 is forecast to raise revenue as it will trigger payment of income taxes on payments that are not being made, and on which no income taxes are currently being paid.

On October 22, 2004, President Bush signed the American Jobs Creation Act of 2004 (AJCA), which contains the provision that permits S corporations sponsoring an ESOP to use distributions from current earnings on both allocated and unallocated ESOP stock to pay the loan used by the ESOP to acquire stock for the employees. The law is now effective as of January 1, 1998.

The legislation, which has many controversial provisions, was passed by the Congress on October 11, 2004. Despite many differences among Members of Congress on the final wording of the bill, there was significant support by both the Senate Finance Committee and the House Tax Committee, as it was the Chair of the Senate Committee, Charles E. Grassley [R-IA], and the ranking Democratic Senator Max Baucus [D-MT], who asked for the ESOP (Section 240 of the legislation) to be included in the final version with the retroactive date.

In 1998, IRS had taken the position that only distributions from current earnings on unallocated shares could be used to pay debt. The provision, just like in the C corporation area, requires that employee owners have stock placed in their accounts that equals their shares of the distributions that is used to pay the debt.

AJCA deals primarily with the U.S. tax regime pertaining to income earned by U.S. corporations overseas and offers tax benefits for domestic manufacturing, the business community, and energy related industries among many others. Clearly the men and women involved with this legislation had no problem with trying to expand ESOPs and helping create more employee owners in

America

For more information about this legislation, please visit The ESOP Association’s web site at www.esopassociation.org. Click on the Advocacy link on the homepage.

On October 11, 2004, H.R. 4520 passed the Congress and will be sent to the President for his signature.

As soon as the President signs the bill, the S corporation ESOP provision is effective, as of January 1, 1998. The S corporation ESOP provision would permit S corporations sponsoring an ESOP to use S corporation distributions (S Corp “dividends”) from current earnings on both allocated and unallocated ESOP leveraged shares to pay the loan used by the ESOP to acquire the leveraged shares.

This alert will be updated when President Bush signs this legislation, providing more details about the application of this provision.

HR4796 Mirrors a Senate Bill Introduced in April

On July 9, 2004, Congressman Cass Ballenger [R-NC] introduced H.R. 4796, the Employee Stock Ownership Plan Promotion and Improvement Act of 2004.

Provisions benefiting both S corporations with ESOPs and C corporations with ESOPs are included, and they are as follows:

These seven provisions, if enacted in total, or singularly, are expected to make ESOPs better for current ESOP sponsors and their employees, and to make creation of ESOPs, particularly S corporation ESOPs, more attractive to current owners.

Original co-sponsors of H.R. 4796 include Eric I. Cantor [R-VA], Virgil H. Goode, Jr. [R-VA], Nancy L. Johnson [R-CT], Ron E. Paul [R-TX], Todd R. Platts [R-PA], and Dana Rohrabacher [R-CA].

In the U.S. Senate, S. 2298, the Employee Stock Ownership Plan Promotion and Improvement Act of 2004, which was introduced by Senator John Breaux [D-LA] on April 6 of this year, is also pending. Original co-sponsors of S. 2298 include Senator George Allen [R-VA], Senator Mary Landrieu [D-LA], and Senator Blanche L. Lincoln [D-AR].

We urge all ESOP advocates to request that their member of Congress co-sponsor H.R. 4796, or thank them if they are co-sponsors.

Without demonstration of significant support for expanding the number of ESOPs in

America

, and for improving the operation of ESOPs for employee owners, the legislation may not pass.

Furthermore, it is important for members of Congress, in addition to Congressman Ballenger, to begin promoting employee ownership through ESOPs in the legislative process as Congressman Ballenger has announced his retirement. By co-sponsoring this legislation, members of Congress will be declaring their endorsement of employee ownership through ESOPs.

The ESOP Associations web site, http://www.esopassociation.org/ has suggested communications to members of the U.S. House of Representatives asking for support of H.R. 4796.

If you wish, contact The ESOP Associations government relations department to review the legislation and its prospects in detail, at govrel@esopassociation.org, or 202.293.2971.

All ESOP companies in North Carolina should send a note of appreciation to Congressman Ballenger, as his consistent commitment to expanding employee ownership through ESOPs is exceedingly impressive as he finishes his distinguished career as a member of Congress.

Senator Breaux Introduces New ESOP Promotion Bill – Senators Allen, Landrieu, and Lincoln Cosponsor

On April 6, 2004, Senator John Breaux [D-LA] introduced S 2298, the Employee Stock Ownership Plan Promotion and Improvement Act of 2004. Demonstrating their strong support of ESOPs, Senator Allen [R-VA], Landrieu [D-LA], and Lincoln [D-AR] have cosponsored the bill.

Provisions benefiting both C and S corporation ESOPs are included, and they are as follows:

The ESOP Association urges all ESOP advocates to respectfully request that their two U.S. Senators co-sponsor Senator Breaux bill, S 2298.

Mr. Ballenger: Mr. Speaker, I’m introducing legislation today to promote employee ownership through employee stock ownership plans (ESOPs). Most of our colleagues are familiar with these plans, but are they aware that the most common form of providing stock ownership to non-managerial employees today is through ESOPs?

During my service in the House, Congress has expanded employee ownership in

America

. I have worked to expand ownership through ESOPs by introducing, cosponsoring and advocating legislation. Many new provisions of ESOP law first surfaced in legislation I introduced in 1990, 1991, 1993, and 1995. Through the years, I have worked to build bipartisan support for ESOPs in Congress.

Let me say to my colleagues that ESOPs are not just special arrangements for the top executives in a company. ESOPs are broad-based stock ownership plans that, over the past 30 years, have created significant wealth for employees. In many instances, they have been the innovators in participatory management practices that respect the individual while maximizing the performance of the company.

Studies demonstrate that the overwhelming majority of employee-owned companies are more successful and treat their employees better than non-employee-owned companies. For example, in the most comprehensive study of ESOP companies ever done, over 1100 ESOP companies were matched against their counterparts for an eleven-year period. The ESOP companies had a survivability rate 15% greater than the non-ESOP companies, had annual sales 2.4% greater on average, and provided more retirement benefits than their counterparts. In another study, Washington State ’s Economic Development Office found in 1997 and 1998 that ESOP companies in Washington State , when compared with non-employee-owned companies, paid higher wages, had better retirement, and had twice the retirement income for employees.

Despite all this favorable data, I cannot say that ESOP companies are always successful. But, I will say that that they are usually high-performing companies that share with employees the wealth they help create and bring a real ownership culture into the workplace.

Overall, we have good ESOP laws on the books through our tax code and the Employee Retirement Income Security Act, which is overseen by the Department of Labor. My legislation does not unravel existing law, nor does it overreach with new, costly tax incentives for ESOP creation. Rather, my bill is a modest step toward aiding the creation of employee ownership through ESOPs and helping existing ESOP companies maximize their ownership structure.

Primarily, the ESOP Promotion and Improvement Act of 2004 would make minor changes in tax law to treat S-corps the same as C-corps in the ESOP arena, which would help foster ESOP creation. My legislation would also extend to ESOPs some of the popular features accorded to retirement programs such as 401Ks. Following is a brief explanation of my legislation:

First, I will clarify what was really an oversight in the drafting of the 1997 law encouraging S corporations to sponsor ESOPs. The 1997 law prevented S corporations from taking a tax deduction for dividends (‘distributions on current earnings’). Since S corporations do not pay a corporate level tax, it is reasonable not to give a corporate level tax deduction. However, under current law, distributions from current earnings on ESOP stock paid to employees of S-corps are subject to a 10% penalty tax because the payments are treated as if they were early withdrawals from plan contributions to the ESOP. Clearly, Congress never intended for S corporations to have their dividends on ESOP stock treated more harshly than C corporation dividends paid on ESOP stock.

To address this problem, my legislation does away with the unfair 10% penalty and makes it clear that, as in C corporations, dividends paid by an S corporation on ESOP stock can be deducted if the deduction is used to pay the debt incurred to acquire the stock for the employees through the ESOP.

Next, my legislation permits the owners of S corporation stock to sell that stock to an ESOP and, under tight rules, to defer the gain on that sale if the following conditions are met. First, the ESOP must hold at least 30% of the outstanding stock of the S corporation. Second, the seller must reinvest his or her proceeds in American companies. This treatment has been permitted for owners of C stock of a private company since 1984, and it has been a boon to ESOP creation. In fact, surveys by the ESOP Association show that 70 to 75% of the ESOP companies in

America

were created by exiting shareholders of private companies using this 1984 law. I believe that if this provision, Code Section 1042, is expanded to include S corporations, there will be many more S corporation ESOPs.

I believe we also need to clarify a 1989 law that the IRS has stretched too far. Under an IRS regulation interpreting the corporate Alternative Minimum Tax (AMT), C corporation dividends that are paid on ESOP stock are calculated as part of a company’s adjusted current earnings, which is used in calculating the corporate AMT. Three taxpayers have taken cases all the way to the Court of Appeals saying the IRS went beyond the reach of the law in this interpretation. However, the Courts have rejected these claims, stating that the IRS has wide discretion in promulgating regulations. We should reaffirm our commitment to ESOP creation and clarify that Congress never intended to make an ESOP benefit a tax liability by overturning these IRS rulings.

Finally, my bill contains two technical amendments clearing up some unfair and out of date elements of the 1984 IRC 1042 provision. My bill clarifies who can participate in a 1042 ESOP, and it permits the proceeds from a 1042 sale to be invested in mutual funds of

U.S.

stock, versus requiring direct stock purchases. In addition, my bill brings parity to ESOPs with other defined contribution plans by permitting ESOP participants to withdraw money from the ESOP under limited circumstances to pay for a first-time home or college tuition.

With these few provisions, my legislation will do much to advance the cause of employee ownership, making ESOPs more effective and fostering the creation of many more ESOP companies. I thank the House and my colleagues for their time, and I ask that they consider joining me by cosponsoring this legislation.

Section-by-Section Explanation of ESOP Promotion and Improvement Act of 2004:

Makes six amendments to the Internal Revenue Code to improve the operation of existing ESOPs for both the plan sponsor and the employee participants, and in some instances make the creation of a new ESOP easier and more attractive.

Section 1. Clarifies that the 1996 and 1997 laws permitting S corporations to sponsor employee ownership through ESOPs allows S corporation distributions on current earnings (referred to as dividends in C corporations) on ESOP shares to be utilized in the same way as dividends under a 1984 law and 1986 law applying to dividends in a C corporation. Specifically, this section would permit the distributions from current earnings by an S corporation on ESOP stock to be passed through to employees without the 10% early withdrawal tax currently imposed on the employees. It would also permit distributions on currents earnings on ESOP stock to be used to pay the ESOP acquisition debt. Regular income tax will still be due and, in keeping with current law, the S corporation would not be permitted a tax deduction for the distributions from current earnings on ESOP stock. *(The distributions from current earnings are not to be confused with regular contributions to the ESOP by the S corporation, which would still continue to be subject to early withdrawal penalties if withdrawn by an employee before death, termination, disability, or retirement.)*

Section 2. Permits the seller of stock to an S corporation ESOP to utilize the current law ESOP tax deferral rollover tax benefit (IRC 1042), under the same restrictions applied to sellers to C corporation ESOPs. In general, to take advantage of IRC 1042, the ESOP most hold at least 30% of the corporation’s highest class of stock at close of transaction, and the seller must reinvest the proceeds of the sale into the equities of operating U.S. corporations. If these conditions and others are met, the seller may defer the capital gains tax on his or her proceeds until he or she disposes of the qualified replacement property acquired with the sale proceeds. Furthermore, the benefit is applicable only to sales of non-publicly traded stock.

Section 3. Reverses a series of federal court decisions that have upheld a 1989 regulation by the Internal Revenue Service that includes tax deductions taken for dividends paid on ESOP stock when calculating a C-corp’s AMT liability. This IRS regulation imposes the corporate AMT under an interpretation of IRC Section 56 that deductible ESOP dividends are included under the preference item known as ACE, or adjusted current earnings. Despite reasoned challenges to the IRS regulation by three taxpayers, courts have upheld the IRS regulations.

Section 4. Makes two minor changes to IRC Section 1042 (first enacted in 1984). The changes would make this ESOP tax benefit more reasonable, particularly due to developments since its enactment. Specifically, this section permits the proceeds from a 1042 sale to be reinvested in mutual funds that are invested in U.S. equities, and provides that an owner of 25% or more of one class of non-voting stock will not be automatically prohibited from participating in an ESOP with 1042 securities, and aggregates the 25% owner restriction on participation in a 1042 ESOP to all of the outstanding shares of the corporation, not just one class of shares.

Section 5. Permits early withdrawals from ESOPs (as with other ERISA plans) for purposes of a first time home purchase or payment of college tuition, with various restrictions, including that the withdrawal may not be more than 10% of an account balance, and the individual has had to participate five years in the ESOP.

In an unexpected decision, Financial Accounting Standards Board (FASB) announced on its web site (www.fasb.org) November 7 that it has “indefinitely delayed” certain aspects of Financial Accounting Standard No. 150 (FAS 150). FAS 150, like other FASB standards, must be used by any company that follows generally accepted accounting principles. FAS 150 was projected to have an adverse impact on the business operations of a vast number of non-public, non-SEC registered firms that have agreements to buy back shares of departing or deceased owners. These companies would have been required to book the value of these shares as a liability, eliminating the net worth of many companies. The indefinite deferral applies to mandatorily redeemable shares of nonpublic companies without a fixed date and a fixed amount. Under the deferral, these shares are not subject to the requirements of FAS 150. Examples include shares redeemable on the death of the holder and shares that are redeemable at the redemption date at fair value.

Earlier today, the House Committee on Ways and Means approved Chairman Bill Thomas’ (R-CA) Substitute Amendment for HR 2896, the “American Jobs Creation Act of 2003.”

This legislation includes an ESOP Association-endorsed amendment to permit S Corporations to use dividends (often referred to as distributions from current earnings) on both allocated and unallocated ESOP stock to pay debt incurred to acquire the employer securities for the ESOP, as is now permitted for C corporations.

The S Corporation ESOP provision reverses an IRS position, and would become effective if and when President Bush signs the bill into law. (The Senate Finance Committee made its version of this provision retroactive effective January 1, 1998.) The bill also includes the following S Corporation provisions: 1. Members of a family treated as 1 shareholder, 2. Increases the number of eligible shareholders to 100, and 3. Expansion of bank S Corporation eligible shareholders to include IRAs.

The ESOP Association will continue its efforts to have current law clarified to permit S Corporation cash dividends to be paid to ESOP participants without subjecting the employee owners to a 10% penalty tax on the dividends. Current law permits cash dividends paid to C Corporation employee owners without imposition of the punitive 10% penalty.

To read the full text of the bill, please visit www.esopassociation.org, click “Advocacy,” click “Capitol Links,” click “House of Representatives,” click "Committees," select "Ways and Means," and click the bullet that states, "Click Here to see the Chairman's mark of the Substitute Amendment to the Jobs Creation Act of 2003." The section of relevance is Section 1051 “Repayment of Loans for Qualifying Employer Securities.”

The legislative prognosis for the “American Jobs Creation Act of 2003,” is uncertain at this time, but we will continue to keep you posted. The bill's primary goal is to revamp the American tax system's taxation of income earned by

U.S.

corporations overseas. The World Trade Organization (WTO) has ruled the current U.S. system to be an unfair trade practice, and has promised massive sanctions against

U.S.

exports, if the tax system is not soon revised.

This agenda summarizes The ESOP Association’s legislative initiatives that are active at this time. For additional details on any of the following descriptions, please consider visiting the “Advocacy” section of www.esopassociation.org.