The tax provisions of the Biden administration’s American Families Plan would provide a substantial, if unintentional, boost to employee stock ownership plans (ESOPs). The proposal would significantly increase capital gains taxes for wealthy individuals, marginally increase the top individual tax rate, and increase the top marginal corporate tax from 21% to 28%. Additionally, the step-up in basis at death would be removed. Whether the changes are good economic policy or not, or are likely to pass in any form, will be hotly debated. But their impact on ESOPs could be dramatic.

Increasing Capital Gains Taxes Would Spur More ESOPs

The long-term capital gains treatment proposal would affect income over $1 million. The gains would be taxed at the highest personal rate of 39.6% over this amount, almost double the current 20%. Most sales to ESOPs are for millions more. The taxes would be in addition to state taxes, which can be as high as 11% in California. The existing 3.8% net investment surtax (the "Medicare surtax") would probably also still apply. The Medicare surtax itself is set to be simplified to apply to those with income over $400,000.

If an owner sells to an ESOP in a C corporation and the ESOP owns 30% or more of the company stock after that transaction, the seller can defer gains on the sale under Section 1042 of the Internal Revenue Code by reinvesting ("rolling over") the gains in U.S. operating companies that make not more than 25% of their income from passive investment. No taxes are due until the new investments are sold, when the gains are taxed pro-rata to their percentage of the original reinvested amount. Currently, if held until death, the basis is stepped up, although the proposal would also remove the step-up in basis "for gains in excess of $1 million ($2.5 million per couple when combined with existing real estate exemptions) and making sure the gains are taxed if the property is not donated to charity."

For details on how a sale to an ESOP works, see our article Using an ESOP for Business Continuity. Also see our booklet Who Should Own Your Business After You?, which you can read online or download.

Let’s take an example of why ESOPs become so attractive in this scenario. Sally sells $5 million in stock to an ESOP. Under the Biden Administration's proposal, her combined state and federal tax is 50%, but she buys a portfolio qualifying under Section 1042, allowing her to defer her capital gains taxes. Historically, a balanced portfolio will about double over a ten-year period, so let's say she holds the portfolio for 10 years and then sells the entire amount. So now she has $10 million, pays $5 million in taxes, and ends up with $5 million left.

Say instead Sally sold to a competitor for the same amount. She would pay $2.5 million in taxes at the time of the sale and have $2.5 million left. She reinvests in the same portfolio and sells 10 years later for $5 million. She has $2.5 million in gains. She would then pay $1.25 million in taxes, netting her $3.75 million. Even if Sally could sell to the competitor for, say, $7 million, she could still end up ahead in the ESOP scenario.

Say that Sally decided to give $2 million to charity. In the ESOP scenario, she buys some stocks and bonds, pays no tax, and gives the whole $2 million to the charity. She gets a $2 million deduction. In the second (non-ESOP) scenario, the charity gets half that and Sally gets a smaller deduction.

Right now, the Section 1042 tax treatment described above applies only to sales of stock of C corporations, but it is possible that Congress will extend this tax break to S corporations in the future.

These scenarios will vary by which state the selling owner lives in, as well as the investment choices the seller makes, but in any scenario, ESOPs become a much more competitive option than a sale to any other buyer.

Since the top marginal rate would rise to 39.6% under the Biden proposal, that might further encourage some very affluent individuals to choose an ESOP if they are facing both income from a business sale and large amounts of taxable income from other sources.

Given the large reservoir of baby boomers who have been waiting to sell their closely held companies, a strong economy, and low interest rates, if anything like these changes happen, ESOPs will be getting a lot of attention.

Removal of Step-Up in Basis (Effect on 1042 Sellers' Heirs)

One thing to keep in mind is the proposed elimination of the step-up in basis at death, which would also affect those who sold to an ESOP in the past if they elected 1042 treatment and plan to hold the assets until death. In the ESOP scenario above, let's say that Sally sold to an ESOP some years ago and now leaves the $10 million portfolio to her heirs. Presently, the heirs would inherit the portfolio with a stepped-up $10 million basis, so they would pay capital gains taxes only if they sold it at a higher valuation later on. In other words, they could sell it immediately with no capital gains tax due. (As for estate tax, the current exemption is $11.7 million, so it does not apply in this example. The Biden proposals do not call for changes to the estate tax.)

Under the Biden proposal, however, the step-up would be taken away, and the estate would immediately owe tax on unrealized capital gains. (Previously, the step-up in basis was released temporarily for one year in 2010 when the estate tax was repealed, but there was an exception for smaller estates.) What's more, instead of a long-term capital gains rate of 20% applying, in this case the amount is above the $1 million threshold for the 39.6% top rate to apply; adding the 3.8% Medicare surcharge, the total federal tax bill would be 43.4%.

Thus, in Sally's case, if she leaves the portfolio from the ESOP sale to her heirs, at present the basis is stepped up, the heirs get all $10 million (at least before state taxes), and federal taxes are due only on the amount the assets appreciate from this point forward if and when they are sold. Under the Biden plan, there is an immediate federal tax bill of $4,340,000 and the heirs get only $5,660,000. Of course, if Sally had not sold to an ESOP, in the scenario above she would only leave $5 million to her heirs (since without the 1042 tax shield only half of the ESOP sale proceeds would have been left to invest), and after taxes this would be reduced to $2,830,000.

The above results mean that simply holding all the reinvested 1042 assets until death, presently a very tax-advantaged strategy due to the step-up, could instead become something to shy away from in a new era of tax planning for owners selling to an ESOP.

Corporate Taxes

The impact of higher corporate taxes would be less dramatic. Higher income tax rates increase the value of deductions. S corporation ESOPs avoid any tax on profits attributable to the ESOP trust at the federal and usually the state level, so they gain a competitive advantage.

ESOP—and all business—valuations would, other things being equal, decline. Since ESOP stock is valued for a hypothetical buyer, and that buyer is assumed to be a C corporation, higher corporate taxes decrease projected cash flow and therefore stock value.