Tax Reform Could Alter Your ESOP Strategy

September 19, 2018

Employee Stock Ownership Plans (ESOPs) have offered a tax-advantaged exit strategy for privately-held business owners since 1974, but Congress recently gave ESOP sponsors reason to take a fresh look at their plans.

Specifically, two provisions of the Tax Cuts and Jobs Act (TCJA) that took effect this year have potentially unfavorable implications for the cost of running an ESOP.

One is applicable to companies that use a discounted cash flow stock valuation methodology. The other pertains to companies whose debt service obligations are somewhat high, relative to their operating profits.

Although the changes are not likely to tip the scales against or in favor of ESOP sponsorship, for companies that already sponsor them or are thinking about doing so, it’s important to be aware of them.

Why Companies and Congress Like ESOPs

Understanding those changes requires a quick review of ESOP taxation fundamentals, beginning with why a company would want to sponsor an ESOP in the first place — and why Congress wants to push them in that direction.

Tax benefits are not usually the primary reason for starting an ESOP. Business owners contemplating an exit may believe that employees are best positioned to run the company after the owner sells out and moves on. And employee ownership provides more security to loyal employees than if the company is acquired by an outsider. It’s about the owner’s legacy, as much as it is a tax strategy.

Congress gave attractive tax breaks to ESOP companies and their owners in the hope that ESOPs would proliferate and create a virtuous cycle of owner-employees building bigger and better companies because they have a direct stake in the enterprise.

Whatever the motivation, today there are nearly 7,000 ESOPs in existence, covering more than 13 million employees, according to the National Center for Employee Ownership (NCEO). Although a few hundred new ones are formed every year, about the same number disappear, leaving a relatively consistent number in operation over the past several years.

ESOP Fundamentals

An ESOP is a qualified benefit plan governed by ERISA, the same sweeping law that covers conventional retirement plans, among other things. Only a very small (5 percent) number of ESOPs are offered by public companies.

The most common ESOP structure and scenario for small companies organized as C corporations is a leveraged ESOP. ESOPs can also be sponsored by pass-through entities like S-corps, but in this article, we’ll focus on C corps. Here are the basics:

  1. An ESOP trust typically is created several years before the owner(s) plan to retire or sell out, with all the legal bells and whistles of a qualified benefit plan. An independent trustee manages the trust.
  2. The corporation borrows money (typically from a bank, but it could be from any other source, including the business owner), and in turn, lends that money to the ESOP trust. The trust uses the proceeds to purchase a substantial proportion of the owner’s shares. Owners typically retain a majority of the voting shares to maintain control of the company while still running the show, but they can sell more shares later when they choose to and when the associated debt service isn’t overly burdensome for the corporation.
  3. The lender’s credit decision is based on the corporation’s ability to service the debt from corporate earnings, so the company needs to maintain positive cash flow. After the financing is in place, the corporation regularly contributes cash to the ESOP trust, which uses those funds to make loan payments to the corporation, which in turn uses them to service the loan. When structured properly, this arrangement enables the corporation to take a tax deduction, in effect, for both the interest and principal payments on the loan.

Tax Deferral Can Be Forever

  1. The company owner invests some or all the cash proceeds from the stock sale (assuming the ESOP winds up with at least 30 percent of the stock) in “qualified replacement property.” That’s IRS jargon for stocks, bonds, and domestic operating companies. By doing so, the owner defers any capital gains tax liability triggered by selling his company shares until he begins to liquidate his qualified replacement property. Alternatively, if those assets are held until the owner’s death and become part of his estate, his beneficiaries receive a “stepped up” tax basis, so that the original gains on the sale of company stock are never taxed. Note: The owner can pledge the qualified replacement property as collateral for the loan. In some situations, that might be necessary to convince a bank to agree to the loan.
  2. Company shares held by the ESOP trust are periodically allocated to employees based on a formula that satisfies the company’s objectives and ERISA’s non-discrimination standards. Employees’ interest in those shares vest based on the ESOP’s vesting schedule, either a three-year “cliff” (going from zero to 100 percent vested after three years) schedule, or a six-year graded (phased) schedule, or a more accelerated pace if that’s what the company wants to do.
  3. When an employee leaves the company, the employee is obligated to sell his vested shares to the ESOP, and the ESOP is obligated to buy them. The prospect of having to make those stock purchases from departing employees is known as the company’s repurchase liability; the ESOP must be liquid enough to meet its repurchase obligations. That means that the regular cash payments by the corporation to the ESOP trust must be sufficient not only to cover the ESOP’s loan repayments to the corporation, but also to cover the ESOP’s repurchase liability.

And here’s were tax reform comes in.

The company must get an annual valuation by an independent valuation firm, in order to gauge and fulfill its repurchase obligations. (The company must also be valued at the front end to ensure that ESOP trust isn’t overpaying for the shares it buys.) Plus, naturally, any lender willing to finance an ESOP transaction would be interested in the company valuation, along with all of the other normal financial documentation.

Tax Reform: A Glancing Blow

Two provisions of the Tax Cuts and Jobs Act (TCJA) enacted last year may impact ESOP taxation for C corporations.

The first is a limitation on the corporate deductibility of interest expense. From 2018 until 2022, it’s limited to 30 percent of EBITDA (earnings before interest, taxes, depreciation and amortization). The adjustment for depreciation, amortization, or depletion applies only through 2021, so the limitation will be much more restrictive for capital-intensive businesses for tax years starting in 2022.

Whether this will impact you as a sponsor of a leveraged ESOP will depend, of course, on the size of the loan the company is carrying that enabled the ESOP to purchase the company shares, plus any other interest expense it is already incurring or expects to.

Also, the extent of the impact would depend upon the company’s effective federal tax rate prior to the TCJA, and the new one-size-fits-all 21 percent rate. You’ll need to crunch the numbers to assess whether the impact is significant or not.

A Change Just for C Corps

A second TCJA change that could affect ESOP sponsors involves the regular valuation of company stock for repurchase liability determination purposes. With the TCJA’s lowering of tax rates for most C corporations (i.e. those with taxable earnings exceeding $50,000), corporate valuations could automatically rise due to increased cash flow, even without any substantial improvement in their financial performance or outlook.

Why is this an issue for an ESOP? It comes back to the repurchase liability.

Given the reduced corporate income tax from 35 percent to 21 percent of corporate earnings, the expected result is an increase in the size of corporate after-tax profits. Those larger projections will, in turn, increase the appraised value of ESOP stock and, therefore, the size of repurchase obligations.

That’s the mathematical result if the valuation is based on discounted after-tax cash flow projections (i.e., the discounted cash flow valuation technique). With a lower tax rate, the after-tax cash flow will be higher, even with the same forecasted pre-tax cash flow as before.

In theory, this is not a problem for C corporations because they will presumably have more cash on hand to cover the repurchase obligation. However, this change will also affect 100 percent ESOP-owned S corporations because their shares are appraised as if they were C corporation shares. Unlike C corporations, however, S corporations will not be generating any more cash than they had been before tax reform, so they will be facing a larger repurchase obligation without a corresponding increase in cash available.

ESOPs, particularly 100 percent ESOP-owned S corporations, will need to anticipate paying a higher price to buy out the vested interests of departing or retiring employees. That, in turn, means the corporation will have to contribute more to the ESOP to facilitate the repurchase.

ESOPs need to assess how the TCJA will impact projected financial forecasts, repurchase obligations, valuations and debt service during the formulation of future strategic, operational and financial goals.

Discuss your ESOP strategy with Cardell McKinstry today.

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