ESOP services legislative updates

Pension Protection Act of 2006

On September 16, 2009 Congressman Ron Kind (D-WI) introduced H.R. 3586, The S Corporation ESOP Promotion and Expansion Act of 2009, to improve and promote S ESOP laws. In general, the bill would: permit owners of S stock to sell their stock to an ESOP under the same treatment C stock of a private company receives under Internal Revenue Code Section 1042, also known as the ESOP cap gains deferred rollover provision; permit a lender to S corporations to exclude 50% of its interest income if the loan is used for a qualified employer securities loan, modeled after former IRC Section 133; permit an S ESOP to assume the estate tax liability of an estate if S stock of equal value is transferred to the S corporation ESOP; and establish a Federal program in the Department of Labor to encourage S ESOP creation. H.R. 3586 was co-sponsored by Congressman Earl Blumenauer (D-OR).

"The ESOP Association will urge Congress to enact this legislation to aid its 1,000 plus S ESOP members nationwide, and to promote the creation of more S ESOPs," said Association President J. Michael Keeling. "We will continue to encourage enactment of new laws, such as S. 1612 by Senator Blanche Lincoln, to aid our approximately 500 C ESOP members as well our S ESOP members," he added.

Association members are encouraged to not only watch their email boxes for more updates on legislative developments impacting their ESOPs, but also to urge their Representatives and Senators to be for pro-ESOP legislative and to stand against any proposals negative to ESOPs.

For more information on contacting members of Congress, download a copy of the Association's Advocacy Kit.

On August 6^th, Senators Blanche Lincoln and Mary Landrieu introduced SR 1612, the ESOP Promotion of Improvement Act of 2009.

The first of the four provisions in the bill would provide immediate stimulus to the U.S. economy, while at the same time increasing the taxes collected by the state and federal governments. This provision repeals the 10% penalty tax on S corporation dividends that are passed through in cash to ESOP participants. The House and Senate should find a way to enact this legislation.

Many ESOP companies are S corporations, and as such, they can pay S distributions (dividends) on the stock of the corporation, just like C corporations. However, in 1998 the IRS declared S corporation dividends to be an in-service distribution to ESOP participants and imposed a 10% penalty tax on S corporation dividends, thus discriminating against employee owners of S corporations.

If the board of directors of a C corporation declares a dividend on stock owned by the company’s ESOP, and that dividend is passed through to ESOP participants, then the ESOP participants would pay ordinary income tax on the dividend they received. I have served on boards of directors where cash dividends were paid to employee owners, and I have seen the positive motivational impact of those cash dividends.

If an S corporation dividend is passed through in cash to the ESOP participants, then ESOP participants would pay ordinary income tax and a 10% excise tax. Consequently, it is virtually unheard of for an S corporation to pay cash dividends to their ESOP participants.

As soon as SR 1612 becomes law, thousands of small to mid-size ESOP S corporations will declare cash dividends to their employees because they have significant amounts of cash sitting in the ESOP, which they know their employees need due to the recession. Most of these companies have tightened their belts in one way or another by cutting benefits, bonuses, and/or direct wages. However, they refuse to pay S corporation dividends only to see the government collect an ordinary income tax and a 10% excise tax from their employees.

I serve on the boards of several 100% ESOP-owned S corporations that have been successful, and as a result, have significant amounts of cash residing in their ESOPs. If the 10% excise tax is repealed, many ESOP companies would pay a cash dividend to employees through the ESOP. If this repeal were to occur in 2009, employees would receive the money in 2009. The taxes paid on this money would stimulate the economy, and federal and state governments would receive more revenue.

The immediate passage of SR 1612 would result in millions of dollars, which are currently “locked” in thousands of ESOPs, being paid to employee owners who could use that cash during this economical downturn. As a result, state and federal governments would receive increased tax revenue that they so desperately need.

ESOP Legislative Bulletin
New Pro-ESOP Provision Proposal Introduced in Senate

On August 6, 2009, Senator Blanche L. Lincoln (D-AR) introduced S. 1612, the ESOP Promotion and Improvement Act of 2009. The legislation has four sections, including an entirely new proposal to remove a 35 year bias against ESOP companies by the Small Business Administration.

One, S. 1612 would repeal the punitive 10% penalty tax on S corporations distributions from current earnings, also referred to as dividends, placed on ESOP stock that are passed through to ESOP participants in cash.

Two, S.1612 would clarify that dividends paid by C corporations on ESOP stock are not a preference item in calculating the corporate alternative minimum tax.

Three, S. 1612 improves the 1042 ESOP tax deferred rollover provisions by (a.) permitting sellers to the ESOP of an S corporation to utilize the ESOP tax benefit referred to as the tax deferred rollover, or the so-called 1042 treatment; (b.) permitting proceeds received from a 1042 transaction to be reinvested in mutual funds consisting of operating U.S. corporation securities; and (c.) redefining what is a 25% owner, for purposes of IRC 1042, as a 25% owner or more of voting stock, or 25% owner or more of all stock of the corporation, instead of current law definition that owning of 25% of any class of stock is a 25% owner for purposes of IRC 1042.

And, four, S. 1612 would eliminate a bias against majority owned ESOP companies by making clear that a non-ESOP small businesses currently eligible for any Small Business Administration program is still eligible for the SBA program if becoming a majority owned ESOP company with the same characteristics it had before becoming a majority owned ESOP company. (A majority owned ESOP company is 50% plus owned by the ESOP on behalf of the employees.)

Senator Blanche Lincoln is the senior Senator from Arkansas elected in 1998 and as the fifth ranking majority member of the Senate Committee on Finance, chairs the Social Security, Pensions, and Family Policy Subcommittee.

Senator Mary L. Landrieu (D-LA) is an original co-sponsor. Senator Landrieu is chair of the U.S. Senate Committee on Small Business and Entrepreneurship as an original co-sponsor.

On February 2, 2009, executive orders signed by the new administration created a series of new rules that will effectively require the management of government contractors to “talk to the union.”

The first executive order requires that all federal contractors post a notice informing employees of their rights under the federal labor laws.

The second executive order impacts all federal contractors and mandates that costs associated with so-called “persuader activities” designed to influence employees to join or not join a union are not reimbursable by the federal government under the government’s contract with the employer.

The third executive order impacts federal contracts covered by the Service Contract Act. The order requires that all service contracts include a clause granting a “right of first refusal” to all employees, except managerial and supervisory employees, employed by the predecessor.

In this context, it is appropriate to examine why non-union ESOP companies have a thirty-five year track record of staying non-union. Union Article [Click here to read more]

Forces are marshaling for legislative attacks on ESOPs when the new Congress convenes in January of 2009. The severity of the attacks and whether or not they will succeed are unknown. However, the attacks could well be severe. They could succeed. They could be launched at the beginning of the new Congressional session, and the cutbacks could be retroactive to January 1, 2009.

The very powerful Chairman of the Ways and Means Committee of the House of Representatives, Charles Rangel, introduced an anti-ESOP provision in 2007 that would cut back some of the benefits available to S Corporation ESOPs. Both Democratic and Republican Congressmen have assured us that the bill will be reintroduced in the new session.

What else might be attacked is unknown. This author feels that S Corporation ESOPs are most likely to be attacked, followed by the IRC 1042 “tax-free” rollover.

About ninety percent of all ESOPs are in small businesses with fewer than five-hundred employees. A substantial number of these ESOPs are sponsored by S Corporations. The new administration is on record as favoring tax increases for small businesses. The revenue that can be gained by cutting back S Corporation ESOP benefits is minimal. However, because Mr. Rangel has already proposed cutbacks in 2007, it is not difficult to imagine Mr. Rangel and his staff proposing additional ESOP cutbacks for S Corporations in the name of “fairness.”

The IRC 1042 “tax-free” rollover is also a small business benefit that is only available to privately-held companies. The rollover entered the 1984 tax code because Senator Russell Long, the legislative father of the ESOP, wished to “level the playing field.” Prior to 1984, the only practical way a small business owner could execute a tax-deferred stock swap and sell their company was to sell to a large publically-traded company. Capital gains taxes on the stock they received in the stock swap were deferred until such time they sold the publically-traded stock. The stock swap was a huge incentive for small businesses (which many of us believe are one of the most productive elements of our economy) to sell out to large publically-traded companies.

The “tax-free” rollover of stock sold to an ESOP allows owners of privately-held companies to reinvest their proceeds in the stock or bonds of U.S. operating companies and to get the same tax benefits (no more or no less) as a stock swap with a publically-traded company. If the ESOP “tax-free” rollover benefit were eliminated, owners of privately-held companies who were unable to execute a stock swap with a publically-traded company would pay higher taxes on the sale of their companies.

Historically, whenever an ESOP benefit has been cut back, whatever was in place was grandfathered. Mr. Rangel’s 2007 ESOP cutback proposal specifically states that anything in place prior to date of enactment is grandfathered. Presumably this same language will be added in ESOP cutback proposals introduced in the new Congress. However, it is very important to understand what has been traditionally grandfathered, and an empty ESOP is no protection. (An empty ESOP is an ESOP that has been adopted by the company’s board of directors but owns no stock.)

What would be grandfathered by the Rangel proposal is the financing arrangements and any other synthetic equity already in place upon date of enactment of a new bill. Applying this approach to new legislation would mean that if an ESOP owned forty percent of the stock of an S Corporation on March 31, 2009, and the special tax status of ESOP-owned S Corporations were eliminated on April 1, 2009, then the special tax status would be retained for the forty percent of the shares already owned. If the ESOP bought the remaining shares of the company on July 1, 2009, the remaining sixty percent of the ESOP-owned stock would not enjoy the special tax status.

Another major concern is the “Tsunami effect,” in which ESOPs get caught up in the major tax bill that will come out of the Ways and Means Committee early next year. (Leading Democrats have already held hearings about reducing tax deductions on 401(k) deferrals.)

Our firm is experiencing one of the busiest fourth quarters in my thirty years as an ESOP consultant. Business owners who have been considering an ESOP for the last few weeks or few years have decided that now is the time to act. Many experts believe that the coming tax increases will not be retroactive to January 1, 2009, and that we have at least until April 1, 2009, to structure ESOP transactions that would be grandfathered. I have no crystal ball, and I cannot be certain that cutbacks will occur. We must assume, however, that when statements regarding tax increases are repeatedly made by Democratic Congressional leaders, including Charles Rangel or the President elect of the United States, that they mean what they say.

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.

Recognition of ordinary income on exercise of stock option in an S corporation with an ESOP.

Under current law, an individual that holds an option in an S corporation in not subject to tax on the income of the S corporation until such individual exercise their option and becomes a shareholder in the S corporation. During the period of time in which an individual holds an option in an S corporation, taxes on the income earned by the S corporation are intended to be paid by the other shareholders in the S Corporation. However, a portion of the S Corporation’s earnings will never be subject to tax if one of the shareholders in the S Corporation is a tax-exempt employee stock ownership plan (an “ESOP”). Certain taxpayers have taken advantage of these aspects of current law by having a tax-exempt ESOP hold a significant percentage of an S corporation’s stock while taxable individuals hold stock options. The combined effect of this structure is that taxable investors are able to benefit from appreciation of the value of the S corporation while a significant portion of the S corporation’s income completely avoids tax. The bill would require these option holders to recognize income when and option is recognized or sold in an amount equal to the amount of income that was shifted to the ESOP through this type of tax planning during the period of time that the option was held such taxpayer. Interest will assessed at the underpayment rate on any amounts included under this provision. This proposal is estimated to raise $606 million over 10 years.

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.

On April 11, 2003, Congressman Cass Ballenger (R-NC) introduced HR 1778, the Employee Ownership for the 21^st Century Act, calling for establishment of a Presidential Commission on Employee Ownership. In a ground-breaking move, HR 1778 mandates the following groups will serve on this commission: three non-management employee owners; three executives of employee-owned companies; three representatives of non-profit organizations committed to employee ownership; three relevant academics; and just three government-affiliated representatives (one from the Department of Labor (DOL), one from the Department of Treasury, and one from the Office of Management and Budget).

The ESOP Association strongly endorses HR 1778. Currently, this legislation has 21 co-sponsors and has not yet been considered in the House Committee for Education and the Workforce. Passage of HR 1778 would result in a coherent, national set of laws designed to promote ESOPs as a policy priority, and would force regulatory agencies to aid ESOPs, rather than stifle them.

On April 30, 2003, Congressman Clay Shaw (R-FL) introduced HR 1896, the S Corporation Modernization Act, calling for amendments the certain laws affecting S Corporations. The ESOP Association is especially sensitive to issues affecting S Corp. ESOPs; the Association represents approximately 800 of these S Corporation ESOPs.

Regarding HR 1896, Section 604 of this legislation, which permits S Corporation ESOP companies to operate with few constraints and less complications, is of interest to The ESOP Association. Section 604, “Distribution by an S Corporation to an Employee Stock Ownership Plan,” would greatly expand the appeal for S Corporations to sponsor ESOPs by removing some of the unintended restrictions on creation and operation of S Corp. ESOPs, particularly when the ESOP holds less than 50% of the stock, that often deter S Corporations from implementing ESOPs.

1. S Corporation ESOP companies should be able to pay dividends on current earnings to employee owners to enhance the value of being an owner, without subjecting employee owners to a punitive 10% excise tax. Non-ESOP shareholders in S Corporations are not required to pay this penalty tax.

2. S Corporation ESOP companies should be permitted to apply dividends to ESOP debt, when the dividends are both on allocated and unallocated shares.

The ESOP Association will continue to advocate an aggressive posture regarding these “fixes” to S Corporation ESOP law.

Following testimony to the Subcommittee on Financial Institutions and Consumer Credit to the House Committee on Ways and Means by three ESOP Association leaders on June 10, 2003, Rep. Bernie Sanders on July 25 introduced HR 2969, the US Employee Ownership Bank Act. (J. Michael Keeling, President, The ESOP Association, Washington , DC ; George A. Ray, Chair, The ESOP Association and CEO/Chair, LeFiell Manufacturing Company, Santa Fe Springs , CA ; and Sherry Ceresa, Statistical Analyst, Gardener’s Supply Company, Burlington , VT , were among the witnesses in this hearing.)

The Employee Ownership Bank Act is designed to provide loan guarantees, subordinated loans, and technical assistance to employees who want to buy their companies through an ESOP or an eligible worker-owned cooperative (E-WOC).

HR 2969 was rolled-out with an impressive list of 16 bi-partisan and original co-sponsors including Rep. Dana Rohrabacher (R-CA) and Rep. Carolyn Maloney (D-NY). According to ESOP Association research, at least 12 of these co-sponsors are, for the first time in their congressional careers, taking a public position for more employee ownership.

The Association’s Board of Directors agreed to support HR 2969 with correction of two minor provisions in the legislation, as it was introduced.

HR 1000, the House version of 2002’s Enron-ERISA reform legislation, passed the US House of Representatives by a vote of 271 to 157 on May 14, 2003. Introduced by Rep. John Boehner (R-OH), Chair of the House Committee for Education and the Workforce, this legislation provides that employees in ALL stand-alone ESOP companies, both publicly-traded and privately-held, are exempt from the bill’s call for three-year diversification out of company stock. In addition, employees at privately-held K-SOP companies are also exempt from the three-year diversification requirement. (A stand-alone ESOP is an ESOP that operates separately from a company’s 401(K) plan. A K-SOP is an ESOP where the employee contribution goes to a 401(K) plan and the employer’s “match” contribution goes to an ESOP in the form of company stock.)

Nearly identical legislation passed the House in 2002, but stagnated because the Senate failed to pass its version of Enron-ERISA reform legislation. It remains to be seen what will happen during 2003.

On September 17th, the Senate Committee on Finance approved Chairman Charles Grassley’s (R-IA) “National Employee Savings and Trust Equity Guarantee Act of 2003 (NEST). 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 is retroactive to January 1, 1998.

The Treasury Department had no objection to the Association-backed provision, authored by Senator Breaux (D-LA). We thank Senator Breaux, his allies, particularly Senators Hatch (R-UT) and Lincoln (D-AR), Chair Grassley, their staffs, as well as the Administration and its Treasury Department.

NEST contains many other provisions that will affect the operation of defined contribution plans, including last year’s Enron-ERISA legislation which specifically exempts stand-alone ESOPs and private company K-SOPs, from new company stock diversification rules.

The legislative prognosis for NEST is uncertain at this time due to controversy primarily over NEST provisions impacting defined benefit plans.

On May 15, 2003 the Financial Accounting Standards Board (FASB) issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.

Statement 150 affects the issuer’s accounting for types of freestanding financial instruments that have mandatory redemption, some put options and forward purchase contracts that obligate the issuers to buy back the shares in exchange for cash or other assets.

Paragraph 17 of the statement provides a scope of limitation that should exclude most shares issued to and held by ESOPs. That paragraph indicates that this Statement does not apply to obligations under stock-based compensation arrangements if those obligations are accounted for under AICPA Statement of Position 93-6 Employers’ Accounting for Employee Stock Ownership Plans or related guidance. As a result, most ESOP companies should not be required to recognize the repurchase liability of their ESOP on their financial statement. However, Statement 150 may apply to a freestanding financial instrument issued under a stock arrangement but is no longer subject to SOP 93-6 or related guidance. (Example - stock previously distributed by an ESOP and held by former ESOP participants that is subject to a put option.)

FAS No. 150 did not resolve all issues. FASB plans to complete a second phase to this project in which they intend to address the accounting for stock compensation programs with characteristics of both liabilities and equity that are not currently covered by FAS 150. Stay tuned!

Presidential Commission on Employee Ownership

Congressman Cass Ballenger (R-NC), a long-time ESOP Champion who has proposed pro-ESOP legislation for more than a decade, has teamed with Congressman Dana Rohrabacher (R-CA), another long-time ESOP Champion, to push Congress to establish a Presidential Commission on Employee Ownership.

The Employee Ownership for the 21^st Century Act, or HR 1778, was introduced on April 11. Two important members of the House Committee on Ways and Means, highly regarded for their expertise in retirement savings issues and the nature of the 21^st Century workforce, signed on as co-sponsors to HR 1778. The support of Congresswoman Nancy Johnson (R-CT) and Congressman Rob Portman (R-OH), senior members of Congress, gives an important endorsement to The ESOP Association’s leadership.

Congressman Ballenger is the third-ranking member of the House Committee for Education and the Workforce, which has jurisdiction over the Department of Labor. Ballenger’s is thus a key voice on the Committee that is charged with considering tomorrow’s workplace, and the welfare of employees in a free enterprise economy. Congressman Rohrabacher, also a senior member of Congress, has since 1999 taken the boldest positions to promote employee-owned and employee-controlled corporations, including being the first person to suggest a Presidential Commission on Employee Ownership.

Most important is the ground-breaking approach Mr. Ballenger takes in who HR 1778 mandates to serve on the Presidential Commission; three non-management employee owners, three executives of employee-owned companies, three representatives from non-profits dedicated to employee ownership issues, and three academics knowledgeable about employee ownership. There would be three government-affiliated members of the Commission: one representative from the Department of Treasury, one representative from the Department of Labor, and one representative from the Office of Management and Budget.

In addition to a Presidential Commission, HR 1778 also calls for a General Accounting Office study of the regulatory and policy positions of federal agencies which often hinder the creation of more ESOPs.

To read the full text of HR 1778, please visit www.esopassociation.org, click “Advocacy”, click “Capital Links”, click “Legislation”, and enter HR 1778 for the 108^th Congress.

President Bush Encourages Employee Ownership

On March 1, 2002, President Bush, speaking on retirement security reform stated “I hope Congress understands it’s a good thing to encourage companies to contribute their own stock to their employees as part of an incentive plan”.

He went on to say “We ought to do everything we can in Washington, D.C., to encourage people to own a piece of the future. The more somebody owns something, the more somebody builds up an asset base, the better off

America

will be”.

He also made a distinction in his remarks between public and private companies.

These statements are the most supportive of employee ownership made by any President since Ronald Reagan. Thank you Mr. President!

Should ESOPs be Subject to Stricter Diversification Rules?
Excerpts from an article authored by Corey Rosen, Executive Director, National Center for Employee Ownership:

To understand this issue, it's necessary to start by understanding there are two distinct ESOP universes: private company ESOPs and public company ESOPs. Fewer than 5% of all ESOPs are in public companies. In private companies, ESOPs are sometimes integrated with 401(k) plans, but their principal purpose is something very different. In most cases, the ESOP is used to provide a market for shares of an owner looking to retire or diversity in a successful business. The remaining ESOPs are generally used as an employee incentive that is an add-on to other benefits.

The research on ESOPs in private companies is very clear: employees in an ESOP are more likely, not less likely, to be in other kinds of retirement plans, have much greater retirement assets than they would otherwise, and get paid more.

Data from Joseph Blasi and Douglas Kruse of Rutgers University show that private ESOP companies are much more likely to have 401(k), profit sharing, and pension plans than non-ESOP companies. It's thus misleading to suggest that ESOPs cause a lack of diversity; in fact, the presence of an ESOP signals companies are more likely to have other kinds of plans, meaning the ESOP is mostly gravy. For instance, 20% of ESOP companies have defined benefit plans, 33% have 401(k) plans, and 33% have profit sharing plans (these are often integrated with a separate 401(k)), and 14% have other retirement plans. Comparable non-ESOP companies do much worse. Only 5% have pension plans, 6% have 401(k) plans, 8% have profit sharing plans, and 2% other kinds of plans.

Data from Washington State are even more telling. A massive study there indicated that ESOP participants get 5% to 12% higher wages than comparable employees in comparable non-ESOP companies, have three times the total retirement assets, and have as much in total diversified investments in the ESOP and other company retirement plans as do comparable employees in comparable non-ESOP companies. So discouraging ESOPs would mean fewer employees would be getting these compensation benefits. If a company were sold to someone else, rather than to an ESOP, employees would end up, in general, with lower wages, less retirement benefits, and no more even in diversified retirement assets.

ESOPs have been a great success in private companies. Changing the law to make them less attractive to employers would be a great disservice to employees. 401(k) plans should be diversified retirement plans and do need to be changed. ESOPs are ownership plans. The data for private companies, where 95% of the ESOPs are, show they function just that way, with companies offering separate retirement plans. It's a law that has worked just as Congress intended.

On June 7, 2001, the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") was signed into law. In general, changes made by EGTRRA increase the amounts that employers may contribute to 401(k) plans, ESOPs and other defined contribution plans. EGTRRA also speeds up vesting of matching contributions and simplifies the rules for "top-heavy" plans. The new provisions begin to go into effect in 2002, but many of the changes are phased in over several years. This issue of "We thought you should know…" presents some highlights of the new retirement plan rules, along with an illustration of the planning opportunities that EGTRRA offers and a chart that compares the previous rules with EGTRRA changes.

· Annual Compensation. The maximum annual compensation of a participant that may be used to calculate contributions and benefits under a qualified retirement plan is increased to $200,000 from $170,000. This limit amount will be indexed for cost-of-living increases in $5,000 increments. Effective: Plan years beginning after 2001.

· Individual Benefit and Contribution Limits. The dollar limit on "annual additions" to a participant's account in a profit sharing, 401(k) or other defined contribution plan is increased from $35,000 to $40,000 in 2002. The alternative limit of 25% of compensation is increased to 100%. For defined benefit plans, the dollar limit on accruals will be $160,000 in 2002. Effective: Limitation years beginning after 2001.

· Elective Deferrals. The annual limit on salary deferrals to a 401(k) plan is increased from the current limit of $10,500 to $11,000 in 2002. The limit will increase by $1,000 in each of the next four years, reaching $15,000 in 2006. This increase also applies to salary deferrals to tax-deferred annuity plans (403(b) plans) and government deferred compensation plans (457 plans). Effective: 2002.

· Contribution Deduction Limits. The limit on an employer's deduction for contributions to a profit sharing or stock bonus plan is increased from 15% to 25% of participants' aggregate compensation. 401(k) deferrals are not counted for purposes of the deduction limits. However, 401(k) deferrals will be included for purposes of calculating the compensation on which this limit is based. The deduction limit for money purchase pension plans remains at 25%. Effective: Taxable years beginning after 2001.

· Catch-up Contributions. Participants who are 50 and older may make catch-up deferral contributions of up to $1,000 in 2002, increasing by $1,000 per year to $5,000 in 2006 (or, if less, the amount of the participant's annual compensation reduced by his or her other deferrals). These contributions do not count against the dollar limit on deferrals ($11,000 in 2002) and are not counted towards the limit on annual additions to a defined contribution plan. The regular limit on tax deductions for contributions to a defined contribution plan does not apply to catch-ups, nor does any limit on deferrals otherwise imposed by the terms of the plan. In addition, catch-up contributions are not taken into account in performing the annual 401(k) discrimination test (the "ADP test"). The catch-up rules also apply to 403(b) and 457 plans. Effective: Taxable years beginning after 2001.

· Faster Vesting for Matching Contributions. Matching contributions are subject to more rapid vesting. These contributions must be 100% vested after three years ("three-year cliff vesting") or must vest at a rate of at least 20% per year beginning after two years of service ("six-year graded vesting"). Effective: Plan years beginning after 2001.

· Prohibition on "Multiple Use" Repealed. Plans may now rely on the "alternative limit" (lesser of 200% or 2 percentage points difference) in discrimination testing of contribution rates for both deferral contributions, and matching and after-tax contributions. Effective: 2002.

· "Same Desk" Rule Repealed. If a company is acquired by or merged into another, the acquired company's plan may now distribute benefits to participants who continue to work at the same job after the merger or acquisition. Effective: For distributions after 2001.

· Hardship Rules Liberalized. 401(k) plans that provide for suspension of a participant's deferrals after a hardship withdrawal may shorten the suspension period from 12 to six months. Effective: 2002.

· Roth Contributions to 401(k) Plan. 401(k) plans may permit employees to make after-tax "Roth" contributions, which will be treated as salary deferrals. These contributions are included in taxable income when made. Neither the Roth contributions nor attributable earnings will be subject to tax in the year they are distributed. Effective: Taxable years beginning after 2005.

· Anti-abuse Rules for S Corporation ESOPs. An excise tax is imposed on an S corporation if share ownership through the ESOP is or becomes highly concentrated among one or more "disqualified persons" (and certain family members) who own shares in the corporation. If the provision is violated, an excise tax equal to 50% of the value of the shares allocated to, or the synthetic equity owned by, the disqualified person is imposed on the corporation. A disqualified person who receives a prohibited allocation is also taxed on the value of the shares allocated to his or her ESOP account. Effective: Generally, plan years ending on or after March 14, 2001. For an ESOP maintained by an S corporation before March 14, 2001, the new law is effective for plan years beginning after 2004.

· Plan Loans for Owner-Employees. "Owner-employees" of an S corporation, a partner-ship or an unincorporated business may now receive loans from a plan on the same terms as other participants. Effective: January 1, 2002.

· Rollover Options Expanded. Tax-deferred rollover treatment is now available for more types of distributions. Distributions from qualified retirement plans, 403(b) plans and 457 plans may be rolled into any of these plans or into an IRA. Distributions from a "contributory" IRA - that is, an IRA to which a taxpayer has made deductible contributions - may now be rolled over to a qualified plan, 403(b) plan or 457 plan. Additionally, after-tax contributions may be rolled over to an IRA or qualified plan or transferred to a qualified plan in a direct trustee-to-trustee transfer. Effective: Distributions after 2001.

· Cash-out Rules. The portion of a participant's account attributable to rollover contributions is not taken into account when determining the account balance for purposes of an involuntary cash-out. A plan may make a distribution without the participant's consent if the account balance is $5,000 or less. Effective: Distributions after 2001.

· Automatic Rollovers. For involuntary cash-outs of between $1,000 and $5,000, the plan sponsor must provide for an automatic rollover to an IRA, unless the participant makes a different election. Effective: Upon issuance of final IRS regulations.

· Small Business Tax Credit. A tax credit for plan administrative and retirement education expenses is available to a "small employer" (an employer whose plan covers at least one non-highly compensated employee and who has 100 or fewer employees earning more than $5,000 each). The credit applies to 50% of the first $1,000 in expenses. Effective: For costs paid or incurred after 2001 for plans established after that year.

· Determination Letter Fees. A small employer (as defined above) is not required to pay a user fee for a determination letter request, subject to certain time limits for the request. Effective: Requests made after 2001.

· Deduction for ESOP Dividend Reinvestment. An employer that maintains an ESOP may deduct dividends on the employer securities in a participant's ESOP account if the participant is given the right to elect either to receive the dividends in cash or to reinvest the dividend in employer securities in the ESOP. Effective: Taxable years beginning after 2001.

· Top-Heavy Rules Liberalized. The rules used to determine whether a plan is top-heavy are simplified. (Top-heavy plans are those in which 60% or more of the assets are held for "key employees."). A key employee is an employee who during the preceding year was (1) an officer with compensation in above $130,000 (indexed in $5,000 increments), (2) a five-percent owner, or (3) a one-percent owner with compensation above $150,000. Key employee status is determined based on the preceding year, rather than the preceding five years. In addition, matching contributions count toward the required 3% minimum top-heavy contribution. 401(k) plans that adopt the "safe harbor" plan design providing for minimum matching contributions are exempt from the top-heavy rules. Effective: 2002.

· Notification of benefit reductions. Current rules requiring sponsors of pension plans to notify participants of amendments that reduce future benefit accruals in money purchase and defined benefit pension plans are changed and expanded. Notice of a reduction must be provided within a reasonable time before the effective date of the amendment (rather than the current 15 days). The penalty for failing to provide the notice is an excise tax of $100 per day, per individual, until the notice is provided. Effective: Amendments taking effect after June 7, 2001.

On June 29, 2001, the IRS announced that plans must be amended by the end of the 2005 plan year to correct provisions that would cause the plan to be disqualified under EGTRRA. A plan sponsor that wishes to adopt permissive EGTRRA provisions - for example, the higher salary deferral limit - must adopt a "good faith EGTRRA amendment" before the end of the year in which the change is to be effective. To adopt the higher deferral limit as soon as possible, therefore, the sponsor of a calendar year plan must adopt a good faith amendment by December 31, 2002. The IRS will issue model good faith EGTRRA amendments before the end of August, 2001.

At present, the IRS will not consider EGTRRA when it issues determination letters. The passage of EGTRRA will have no effect on the deadline for adopting amendments to comply with GUST or filing amended plans for a favorable determination letter.

As illustrated by the attached example, EGTRRA offers employers the opportunity to make changes in their plans that will be helpful to employees and financially beneficial to employers. If you would like to discuss the EGTRRA provisions in more detail or to analyze the impact of EGTRRA on your plan, please don't hesitate to contact us.

This example demonstrates some of the opportunities created by EGTRRA. It shows the effect of the deduction and allocation changes provided under the new tax law for a company that maintains both an ESOP and a profit sharing plan with a 401(k) feature:

For the 2001 plan year, the Acme Dynamite Company would like to make a discretionary employer contribution to its ESOP equal to 20% of participants' compensation. Aggregate salary deferrals to the 401(k) Plan are equal to 5% of participants' compensation. Wiley Kiyote, a participant in the ESOP and the 401(k) Plan, earns $50,000 in compensation and elects to have $10,000 contributed as a salary deferral to the 401(k) Plan.

The limit on deductible contributions in 2001 is 15% of participants' compensation. Because salary deferrals to the 401(k) Plan are equal to 5% of participants' compensation, the maximum amount that Acme may contribute to the ESOP is 10% of participants' compensation. For Wiley, this would result in an ESOP contribution of $5,000 (10% of $50,000) plus his $10,000 401(k) contribution, for a combined contribution of $15,000.

Wiley's contributions for 2001 are also subject to an individual allocation limit, which is the lesser of 25% of his compensation or $35,000. Because of this individual limit, Wiley's contributions under both plans may not exceed $12,500 (25% of $50,000). Consequently, Wiley's 2001 contributions must be reduced by $2,500 ($15,000 minus $12,500), either by reducing his allocation under the ESOP or by returning to him a portion of his salary deferrals as taxable compensation.

In 2002, the result is very different, although the facts are the same. Acme still intends to make a 20% employer contribution to the ESOP. Aggregate elective contributions still equal 5% of participants' compensation. Rhoda Runner (Wiley's replacement after his unfortunate fall from a cliff) earns $50,000 in compensation and elects to have $10,000 contributed as a salary deferral to the 401(k) Plan.

The limit on deductible contributions in 2002 is 25% of participants' compensation. Because salary deferrals to the 401(k) Plan are disregarded for purposes of the deduction limitation, Acme could contribute as much as 25% of participants' compensation to the ESOP, as compared with 10% in 2001. Acme's chosen rate of 20% would produce a $10,000 ESOP contribution for Rhoda, and a combined contribution of $20,000 to both plans--$5,000 more than Wiley's 2001 combined contribution.

Furthermore, Rhoda's plan contribution will not be affected by the individual allocation limit. In 2002, this limit is increased to the lesser of 100% of her compensation or $40,000. Because Rhoda's annual addition is less than $40,000, no reduction is necessary. Rhoda's contributions in 2002 will be $7,500 more than Wiley's, although their compensation and contribution rates are the same.