The IRS, ESOPs, and the Greater Good
On August 8, the IRS issued a press release warning about tax avoidance in employee stock ownership plan (ESOP) transactions. It is not clear what prompted the memo or whether there are any specific transactions that the IRS is investigating.
The IRS targeted abusive ESOPs once before. In 1997, when legislation first allowed ESOPs to own S corporations, some advisors started promoting plans that provided no benefits to employees but allowed large tax savings to wealthy individuals, business owners, and executives. That was an appropriate effort backed by the ESOP community. The current effort is part of the IRS’s focus on tax avoidance by wealthy individuals, and may be intended to target a limited scope of abusive proposals. Unfortunately, the IRS may inadvertently be damaging one of the most successful programs of the last 50 years to build middle- and working-class wealth.
The Impact of ESOPs
Let’s start with the data. Almost 50 years ago, Congress decided that it was good public policy to support ESOPs, and since then, Congress has passed 17 pro-ESOP laws. The consistently bipartisan and often virtually unanimous support rests on two ideas: that employee ownership provides financial security to working people and that it improves the competitiveness of American companies. Fifty years of data show that policymakers were right on both counts.
First, employee ownership is an exceptionally powerful mechanism to provide wealth to people who wouldn’t otherwise have it. The data show that employees have two to three times the retirement wealth as comparable employees who have access to retirement plans in similar non-ESOP companies–and 50% of the private sector workforce participates in no retirement plan at all. Federal data also shows that among millennial workers, participants in ESOPs have 92% greater household wealth than those not in ESOPs, and this advantage extends to every demographic group included: single parents, non-college educated, people of color, etc.
Congress’s second correct assumption is that employee-owned companies outperform their peers. Their increased productivity is one reason they lay people off at roughly one-third the rate of other companies and have dramatically lower termination and quit rates.
Like any business tool that involves complexity and non-trivial dollars, abuses exist. As I write this, we here at the NCEO have not yet communicated with the IRS about their press release, so we do not know what they intend to warn about, but two possible transaction structures may be their targets. Both are extremely complex and will best be understood by people with a background in ESOP transactions, but their basic terms are clear:
- One transaction identified by an ESOP advisor creates a series of steps where the business owner sells the company to employees and then receives almost half of it back. (For those interested in the mechanics of the transaction, in this scenario, the company takes a loan to redeem 99% of the owner’s outstanding shares. An ESOP then purchases the remaining 1% of shares. Of that 1% of the original shares, which now are 100% of the outstanding shares, 49% are purchased by the ESOP using 401(k) plan rollover dollars in a Roth conversion of the seller’s account, so 49% of the company is allocated to the seller within the ESOP. The ESOP also uses a leveraged purchase for the other 51% of the shares for the benefit of all employees allocated over a long internal loan period. The end result is that the seller and/or management have an opportunity to buy 49% of the company through the rollover for a nominal price, fully vested and tax-advantaged through the new ESOP, while the rank-and-file employees get 51% of the stock. This transaction may meet the letter of the law, but it is certainly not what Congress intended.)
- A second form of transaction has the ESOP stretching the employee benefit over an extremely long time, such that most of the value of the shares would not be available until after the current workforce has retired. (In this case, the ESOP acquires all of the stock through an extremely long-term internal loan – one professional reports seeing a 150-year term! Since the benefit to employees tracks the loan repayment, as much as 80% percent of the shares acquired by the ESOP would then be allocated after the normal working lives of the company’s current employees. Often, the expectation is that the company may be sold in the interim, resulting in a greater benefit to management holding synthetic equity rights or sellers holding warrants. With a proper analysis of employee benefit levels, a long loan term can make sense for everyone involved, but loans that last longer than most workers' remaining lifetimes can be abusive.)
Even though the positive impact of employee ownership as a whole suggests abusive cases are outliers, it is right to work against them. There is a legitimate role for the IRS, the Department of Labor, and for the plaintiffs’ bar.
We believe the employee ownership community as a whole has an obligation to help ensure that people who sell their businesses to ESOPs do so in a way that supports the letter and spirit of the law, just as it did with S corporation ESOP abuses in the 1990s. The ESOP community promoted legislation to stop these abuses, Congress acted quickly, and the abuses ended.
The time may have come again for the ESOP community to identify and discourage abusive transactions while seeking new ways to facilitate the transactions that meet Congressional intent, from research and tools developed by nonprofit organizations to best practices for service providers to ideas for anti-abuse policy, as was done with the S corporation anti-abuse legislation. Otherwise, we may see a proliferation of regulatory and litigation activity to the detriment of the future of ESOPs generally.
Derailing a Virtuous Cycle
Abusive transactions are a very small part of the ESOP landscape. I mentioned two conclusions of ESOP research above – that employee ownership broadens the ownership of wealth and that ESOP companies outperform their peers. Unfortunately, the research also leads to a third conclusion: the growth of employee ownership shouldn’t be taken for granted. ESOP companies tend to be excellent targets to be bought out. That’s not a bad outcome – it’s part of the market economy, and employee-owners receive greater value and more liquidity when an ESOP company sells – but it does mean that the employee ownership community is a leaky bucket, and its growth depends on at least as many new ESOPs being created per year as the number that leave.
At the NCEO, we talk with business owners who set up ESOPs, but we also talk with those who consider and reject ESOPs. For that group, one common explanation is their fear of the transaction’s risks. Objective comparisons of an ESOP versus an outside buyout often favor an ESOP, but fear is not rational.
The IRS may have intended its press release to focus narrowly on a small subset of ESOP transactions, but its impact is to discourage all ESOP transactions. Many business advisors are ready to give their clients reasons to be suspicious of ESOPs, and the IRS’s press release has certainly already been added at the top of the list in those advisors’ PowerPoint slides on ESOPs.
If the IRS inadvertently discourages the formation of even a portion of the new employee-owned companies that would have happened in the coming years, the ESOP trendline could bend downward.
The Greater Good
Speaking at the annual employee ownership conference this year, Greg Graves, the former CEO of employee-owned engineering firm Burns & McDonnell, said, “We don't create billionaires at Burns and Mac, but for every billionaire we don't create, we create a thousand millionaires." He’s right, and we need more companies like that.
A socially beneficial economy is one with effective businesses in which employees think and act like owners, and in which workers share in the wealth they work hard to create. Employee ownership makes companies stronger, and every company that becomes employee-owned motivates other companies to become employee-owned as well. Employee ownership has the potential to be a virtuous cycle, and in an economically rational economy, it will.