Is a Flat Tax a Threat to ESOPs?

If Congress passed a flat tax, what would happen to ESOPs and other tax-favored employee ownership plans? At first blush, the answer might seem they would disappear. If there were no more tax deductions, there would be no more tax incentives. In fact, the situation is more complicated.

While a flat tax on personal income is fairly straightforward, it is more difficult to calculate for corporations. After all, the tax is on profits. But before a company can determine profits, it has to determine costs. These costs would still have to be deducted from revenues. So the key issue is how costs are defined. In the flat tax bill proposed by Ways and Means Committee Chair Bill Archer, compensation costs would be deductible, including contributions to retirement plans. In fact, Archer would eliminate any limitations on these contributions and any allocation rules. Presumably, leveraged and non-leveraged ESOPs would still be allowed and would still provide a tax-favored way for companies to acquire stock for employees.

On an individual basis, a flat tax would mean the elimination of the tax deferral available for sales to ESOPs owning at least 30% of the shares or privately held firms. That could have a significant impact, although probably not as great as most people believe if a sale to an ESOP continues to qualify for tax benefits at the corporate level. A sale to an ESOP would still be the most tax-efficient way for most business owners to plan for a sale.

But don't hold your breath on any of this. The last time Congress tried to move towards a flat tax (in the late 1980s) we ended up with a law that started out simpler and ended up more complex. Archer's proposal to eliminate restrictions on retirement contributions would be enormously expensive. And once a flat tax is actually seriously proposed, everyone whose deductions are threatened will be making the case for why their case is special. Eliminating mortgage deductions, for instance, would devastate the real estate market. A flat corporate tax would mean raising the tax rate on most businesses and lowering it for large companies, a political proposition that could be hard to advance.