Tax Reform Bill Could Impact ESOP Deductions

The Tax Cuts and Job Act does not change legislation for Employee Stock Ownership Plans (ESOPs) but it could have some indirect effects with regards to their taxes, according to an Employee Ownership Update written by Loren Rogers, executive director of the National Center for Employee Ownership.

The tax bill limits net interest deductions for business to 30% of earnings before interest, taxes, depreciation and amortization (EBITDA) for four years, but starting in 2022, it will exclude deductions on earnings before depreciation and amortization; in other words, Rogers says, “businesses will subtract depreciation and amortization from their earnings before calculating their maximum deductible interest payments.”

Rogers says that for new leveraged ESOPs that borrow a large amount relative to its EBITDA, they “may find that their deductible expenses will be lower and, therefore, their taxable income may be higher under this change.” However, 100%-ESOP owned S corporations will not be affected because they do not pay tax, he says.

“Many questions remain on the impact of this change,” Rogers says. “Importantly, it is not yet clear whether the limit on deductibility of interest will apply to loans made after the bill goes into effect or if it will apply retroactively. It is also unclear what impact the bill will have on alternative structures, such as replacing simple interest with warrants or payment-in-kind interest.”

Because the bill reduces corporate income tax from 35% to 21%, corporate after-tax profits will rise, he says. For ESOP plans, the value of their stock will also rise, as will the size of their repurchase obligation, Rogers says. In theory, the repurchase obligation should not be a problem for C corporations since they should have more cash on hand, he says.

The situation for 100 ESOP-owned S corporations could be trickier, he says, due to the fact “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 before tax reform, so they will be facing a larger repurchase obligation without a corresponding increase in cash available.”

State and local taxes

In states with higher tax rates on capital gains, sellers of businesses may want to use Section 1042 of the Internal Revenue Code, he says. This allows a company to defer federal taxation on the sale of stock to an ESOP. “If, for example, an owner in California sells $5 million in stock to a non-ESOP buyer, the seller would pay 10% of that in California taxes,” Rogers says. “The bill imposes a cap of $10,000 on the amount of state and local income taxes that can be deducted from gross income. Under pre-reform law, that $500,000 [that the seller would pay in California taxes] would have been deducted from the seller’s federal gross income, but the tax reform bill would limit that deduction to $10,000. In other words, the effective tax rate on the sale probably goes up by around $180,300 ($490,000 times the taxpayer’s marginal federal rate of 37%).”

The bill allows S corporation owners to deduct 20% of their income, Rogers continues. “The owner of an S corporation that makes $1 million in income annually would have $1 million in taxable income in 2017, but they would have $800,000 after the tax law comes into effect in 2018. That makes the S election marginally less appealing, but it may not be enough to change the calculation about being ESOP-owned or being a C or S corporation in all but a handful of cases.”

For S ESOPs that are not 100% owned, the law would reduce the required distributions by 20%. Rogers explains: “S corporations must allocate distributions pro rata to earnings. Most S corporations make distributions to non-ESOP owners so they can pay their taxes on their share of corporate profits. So, if an ESOP owns 30% of the company, it gets 30% of the distributions. These distributions now will be somewhat smaller because the non-ESOP owner will be declaring 20% less income and, therefore, requiring a smaller S distribution.”

Rogers’ full report can be viewed here.