Federal Legislation on ESOPs

Congress has been very supportive of ESOPs since their creation in 1974. There have been multiple added tax incentives, although some were later repealed. In addition, there have been two laws to facilitate SBA financing for ESOPs, two to mandate ESOPs as part of government bailouts of private companies, and one to limit abuses of S corporation ESOP tax incentives. This summary provides a very brief description of these laws. The laws contain a number technical provisions not included in this summary.

In addition, this article describes legislation currently proposed. It is limited to those proposals that have at least made it to committee consideration.

This article only provides brief descriptions of what are often complex laws. Details about most of them are readily available through a search on the NCEO site or newsletters for more recent legislation (1997 and forward).

ESOPs were actually created by Louis Kelso in the 1950s, and the first ESOP installed in 1956. Until 1974 and the passage of the Employee Retirement Income Security Act (ERISA), about 300 plans were set up using existing stock bonus plan law and approved one-by-one by the IRS.

1973: The Regional Railroad Reorganization Act

The first mention of ESOPs in federal law was the 1973 Regional Railroad Reorganization Act, which created Conrail to subsume a number of railroads into a single company. Under this legislation, Conrail was required to set up an ESOP that would own 15% of Conrail stock, with the government owning the rest. The government later disposed of its stock and Conrail went public in 1987.

1974: Employee Retirement Income Security Act (ERISA)

ERISA was a major legislative overhaul of retirement, health, and other employee benefit plans designed to deal with various abusive practices, especially in pension plans. ERISA essentially codified the existing ESOP by making it part of retirement plan law and subject to most of the same requirements for eligibility, vesting, and allocation. ESOPs were allowed a longer distribution schedule than other defined contribution plans, however. Critically, ERISA stated that ESOPs were exempt from the normal prohibited transaction rules that prevented retirement plans from purchasing shares from a party in interest (an existing owner) and from borrowing money. ERISA also exempted ESOPs from normal diversification rules by requiring that they be invested primarily in company stock. ERISA did not add any new tax benefits, which at the time were primarily limited to the deductibility of contributions to the plan up to a limit of 15% of eligible pay, but it did make it clear that this was the law and not something to be applied case-by-case. ERISA also established that the trustee of the ESOP was the legal owner.

1975: Tax Reduction Act of 1975

This law created the Tax Reduction Act ESOP (TRASOP) by providing an additional one percent tax credit for qualifying capital investments if the company contributed an equivalent amount of stock to an ESOP.

1978: The Revenue Act of 1978

The Revenue Act of 1978 created Section 409(A) of ERISA, which spelled out for the first time the requirement that shares on a private company be subject to a fair market valuation. It codified regulations for TRASOPs, and specified that distributions could be made in cash or in stock, but the employee must have a put option for stock distributions. Employees must be able, however, to demand that distributions be made in the form of shares.

1979: The Technical Corrections Act of 1979

The Technical Corrections Act of 1979 clarified an uncertain area of the law by stating that leveraged ESOPs were subject to the same 409(A) rules as other ESOPs.

1979: The Chrysler Loan Guarantee Act

The Chrysler Loan Guarantee Act provided emergency credit to rescue Chrysler from bankruptcy. As part of that, it required Chrysler to set up an ESOP with $162.5 million.

1980: The Small Business Employee Stock Ownership Plan Act

The Small Business Employee Stock Ownership Plan Act provided that the SBA be able to make loans directly to ESOP trust. At the time, this was the typical transaction, but the SBA had ruled that such loans were impermissible because the trust was not a small business. The SBA largely ignored the law, however.

1981: The Economic Recovery Act of 1981

The Economic Recovery Act of 1981 eliminated TRASOPs and replaced them with Payroll Based ESOPs (PAYSOPs), providing the employer with a .5% credit against payroll for contributions to an ESOP. The law provided that companies with a majority of their stock held by employees could require that distributions be made in cash.

1984: The Tax Reform Act of 1984

The Tax Reform Act of 1984 added the most significant ESOP-specific tax benefits. These included:

• IRC Section 1042: Allowed sellers to a worker cooperative or to an ESOP owning at least 30% of the stock in a C corporation to defer capital gains taxes by investing in stock and bonds of U.S. operating companies.
• IRC Section 133: Lenders to ESOPs could exclude 50% of the interest income from their taxable income for loans to an ESOP.
• IRC Section 404(k): Provided that dividends passed through to employees would be tax-deductible.
• The tax credit for PAYSOPs was frozen until 1987.

1986: The Tax Reform Act of 1986

The Tax Reform Act of 1986 made a number changes to ESOPs, most notably:

• Permitted the exclusion of 50 percent of the qualified proceeds from a qualified sale of employer securities from an estate to an ESOP or worker cooperative.
• Modified the 50% exclusion on interest income from loans to ESOPs to apply only to loans to the trust of seven years or less.

1989: Omnibus Budget Reconciliation Act of 1989

The Omnibus Budget Reconciliation Act of 1989 limited the 50% interest income exclusion on ESOP loans to ESOPs acquiring at least 50% of the stock in the company. It also repealed the estate tax exclusion for sales to an ESOP.

1996: The Small Business Job Protection Act of 1996

The Small Business Job Protection Act provided that S corporations could have ESOP trusts as owners, provided the ESOP trust paid unrelated business income tax on its pro-rata share of profits. 

The act also repealed IRC Section 133, the provision allowing the exclusion of 50% of the interest on qualifying loans to ESOPs.

1997: Taxpayer Relief Act of 1997

This bill repealed the unrelated business tax requirement for ESOP trusts in S corporations, meaning that profits attributable to the ESOP’s ownership would not be subject to income tax.

2001: The Economic Growth and Tax Relief Reconciliation Act

In response to abuses of the S ESOP corporation tax benefit, this law created a set of anti-abuse requirements (section 409(p)) for ownership in an S ESOP designed to prevent ownership from being concentrated in the hands of a limited number people.

The bill also increased the percentage of compensation that could be contributed to ESOPs from 15% to 25% of eligible pay.

2006: Pension Protection Act of 2006

The Pension Protection Act of 2006 required that employees be able to move employer stock out of their 401(k) plans and ESOPs. For employer non-elective or matching contributions, the diversification requirements apply after the participant has completed at least three years of service. For elective deferrals and after-tax contributions, the diversification requirements apply immediately. Stand-alone ESOPs without elective employee or matching contributions were excluded from the new diversification rule.

The Act also shortened the maximum vesting period for defined contribution plans to six years.

2018: The Main Street Employee Ownership Act

The Main Street Employee Ownership Act updated rules for the Small Business Administration to make lending to ESOPs more practical than under existing rules. The SBA issued operating procedures, however, that largely vitiated Congressional intent.

2021: The National Defense Authorization Act of 2021

The National Defense Authorization Act of 2021 contains the first-ever government contracting program to specifically encourage ESOPs. Under a five-year pilot program, DOD contracting companies that are or become 100% ESOP-owned qualify for noncompete follow-on contracts for the work.

The bill also directs the Department of Defense to look at “acquisition authorities that could be used to incentivize businesses to become qualified businesses wholly owned through ESOPs and to overcome challenges to partnering with the Department.”

2021: The State Small Business Credit Initiative

The American Rescue Plan Act of 2021 (P.L. 117-2) included an appropriation of $10 billion for another round of funding for the State Small Business Credit Initiative (SSBCI), a program that has been in place since 2010. The SSBCI program was created to increase access to capital for economic development through small business. Funding has not been historically available for business transactions, but in a floor dialogue on the bill, Congress directed the Treasury Department to include transitions to employee ownership in the program. Under the program, states programs can (but are not required) to use the money both for direct loan support and technical assistance for employee ownership conversions.

2022: The CHIPS Act of 2022

The CHIPS Act of 2022 created regional technology and innovation hubs. Included in a long list of eligible recipients for training grants from the program are organizations that promote employee ownership. The bill also directs Manufacturing Excellence Programs under the National Institute of Standards and Technology to include employee ownership in their list of potential outreach efforts.

2022: The WORK Act

The Consolidated Apprpriations Act of 2023, an omnibus spending bill, had three provisions on ESOPs, all under the part of the bill called the WORK Act. 

The bill would create a federal program to fund state employee ownership outreach and training programs. Under the law, the Department of Labor would establish an Employee Ownership and Participation Initiative to promote employee ownership and employee participation in business decision-making. The program would be funded at $4 million in fiscal year 2024, gradually increasing to $16 million by fiscal year 2028. The DOL set up the initiative in 2023. Funding for the grant program will depend on whether Congress makes an appropriartion for it in 2023 or a subsequent year.

The funds can go to existing state programs or to create new ones. States can contract out the work to qualified organizations or create the program in-house. If a state does not apply, nonprofits can apply in the following year. Funds can be used for training, technical assistance, and working with local organizations to help business owners understand how employee ownership through ESOPs, worker cooperatives, or employee ownership trusts can be used for business succession.            

The bill would also require that the Department of Labor to develop “acceptable standards and procedures to establish good faith fair market value for shares of a business to be acquired by an employee stock ownership plan.”  ESOP advocates have long sought this clearer guidance on ESOP valuations, arguing that the lack of standards has led to unwarranted ESOP litigation.

Finally, the bill provides that sellers to an ESOP in an S corporation can defer 10% of the tax on the gain by reinvsting in stocks and bonds of U.S. operating companies. The tax deferral is based on the 100% tax deferral available for sale to an ESOP in C corporations. It was limited to 10% because of budget concerns.

Proposed Legislation 2023

Promotion and Expansion of Employee Ownership Act Introduced in Both Houses

The Promotion and Expansion of Private Employee Ownership Act has been introduced in the House and the Senate. The bill is a revision of a proposal submitted in each Congress to encourage the growth of Corporation ESOPs. Both bills have bipartisan support. The Senate bill’s lead sponsors are Ben Cardin (D-MD) and Steve Daines (R-MT); in the House the lead sponsors are Earl Blumenauer (D-OR) and Mike Kelley (R-PA). There are 19 Senate cosponsors and six House cosponsors so far, including some of the most liberal and conservative members.

The bill would:

• Move up the effective date of the 10% deferral of capital gains taxation from the sale of shares in an S corporation ESOP owning 30% or more of the shares from 2027 to 2023 and provide that the deferral would be for 100% of the gain, as is currently the case for the sale of stock to an ESOP in a C corporation that owns at least 30% of the shares.
• Create an S Corporation Employee Ownership Assistance Office in the Department of the Treasury to provide education and outreach on S corporation ESOPs..
• Grandfather any ESOP company that had qualified for set-aside programs through the federal government to be able to continue to qualify after an ESOP gains controlling interest.
• Direct the Secretary of Labor to appoint an Advocate for Employee Ownership within the Employee Ownership Initiative established under the WORK Act provisions of SECURE 2.0. The Advocate would help coordinate federal programs that could support ESOPs and “work with the DOL to provide assistance for purposes of resolving a dispute with the Department of Labor” to an ESOP company, participant, or fiduciary. An annual report would be required.

Employee Equity Investment Act

The Employee Equity Investment Act would create an investment facility within the Small Business Administration's (SBA's) Small Business Investment Company (SBIC) program to provide loan guarantees for investment funds devoted to expanding employee ownership.

EEIA would create a public-private partnership that works like existing SBIC loans but with a focus on employee ownership. The program would provide federal backing for Employee Equity Investment Companies (EEICs). EEICs would raise their own funds but would receive federal loan guarantees to provide debt at more reasonable costs and/or equity infusions into transactions in which an ESOP ends up with at least 30% of a company or already owns that much and is seeking growth capital. The debt would normally be subordinate to other lenders. EEICs would pay fees into the program, and, like the regular SBIC program, would operate at a zero-subsidy cost to the federal government. EEICs would be funded by a similar mechanism as existing SBICs, where the SBA issues unsecured debt instruments called debentures based on loans the SBICs make. These are pooled and sold as securities as an SBA-guaranteed bond with a fixed interest rate at a standard premium over Treasury notes. The legislation lays out detailed capital and other requirements for EEICs to qualify.

The proposal seeks to address the problem faced by many potential sellers to an ESOP: to sell much or all of the company, they almost always have to take part of the payment in the form of a note. While many sellers are willing to do that, many others want or need more money up front. To do that with an ESOP, they would have to find very costly junior debt, and even that is available only for larger deals. That means many sellers just end up selling to a non-ESOP buyer.