The Consolidated Appropriations Act of 2023, an omnibus spending bill with many parts that was signed into law on December 29, contains major wins for employee ownership as part of the SECURE 2.0 Act of 2022. (The original SECURE [Setting Every Community Up for Retirement Enhancement] Act of 2019 was signed into law in December 2019 and modified various retirement plan rules, such as changing the age for required minimum distributions from 70½ to 72.) Section references here are to the SECURE 2.0 Act, not the appropriations bill as a whole, which contains many laws (e.g., there are multiple “sec. 114” instances, and one of them is in the SECURE 2.0 Act, amending Section 1042).

The most important change for employee ownership is the passage of the Worker Ownership, Readiness, and Knowledge (WORK) Act, the most important pro-employee ownership legislation since the legislation in the 1990s allowing S corporations to have ESOPs. The WORK Act provisions (incorporated into the bill as Section 346 of the SECURE 2.0 Act) (1) direct the Department of Labor (DOL) to create an Employee Ownership Initiative within the department to coordinate and fund state employee ownership outreach programs and (2) require the DOL to set new standards for ESOP appraisals.

The SECURE 2.0 Act also amends, effective starting in 2028, Section 1042 of the Internal Revenue Code to extend to S corporation owners the tax deferral for those who sell to ESOPs and reinvest in stocks and bonds of U.S. operating companies, but only for up to 10% of the proceeds (not 100%, as for C corporation owners).

Other SECURE 2.0 provisions affect ESOPs and other retirement plans in various ways, discussed below.

We will update this post if we learn of changes or corrections.

The WORK Act’s Employee Ownership Initiative

The WORK Act (section 346 of the SECURE 2.0 Act, “Worker Ownership, Readiness, and Knowledge”) requires the Department of Labor to establish an Employee Ownership Initiative to promote employee ownership and employee participation in business decision-making. The program is to be funded at $4 million in fiscal year 2025 (which starts in October 2024) , gradually increasing to $16 million by fiscal year 2029. To continue after that, Congress would need to create a new appropriation for the program.

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 fiscal year.

Program funds would be used for:

“(A) providing education and outreach to inform employees and employers about the possibilities and benefits of employee ownership and business ownership succession planning, including providing information about financial education, employee teams, open-book management, and other tools that enable employees to share ideas and information about how their businesses can succeed;

“(B) providing technical assistance to assist employee efforts to become business owners, to enable employers and employees to explore and assess the feasibility of transferring full or partial ownership to employees, and to encourage employees and employers to start new employee-owned businesses;

"(C) training employees and employers with respect to methods of employee participation in open-book management, work teams, committees, and other approaches for seeking greater employee input; and

“(D) training other entities to apply for funding under this subsection, to establish new programs, and to carry out program activities.”

The bill directs the DOL to perform its function in carrying out the Employee Ownership Initiative by making state-level grants, acting as a clearinghouse on techniques employed by new and existing programs and existing state-level programs, and funding projects for information gathering on those techniques by groups outside the DOL (and disseminating that information).

Funds can be used for educating business owners about using employee ownership for business transition, providing information on starting employee-owned companies, training employees and employers on workplace participation programs, and providing technical assistance to assess the feasibility of transactions. Funds also can be used to help pay for feasibility studies; provide materials for outreach and training; create a data bank on where to find legal, financial, and technical advice in connection with business ownership; and create networks of employee-owned companies.

States can “sponsor and submit an application . . . on behalf of any local entity consisting of a unit of State or local government, State-supported institution of higher education, or nonprofit organization,” as well as submit an application on their own behalf. If a state fails to support or establish such a program in a given fiscal year, then in subsequent fiscal years, such local governmental, educational, or nonprofit entities can apply for grants on their own initiative.

The WORK Act is based on a bill NCEO founder Corey Rosen wrote for Senator James Sasser in 1987. Sasser had asked the NCEO to develop ideas for how to encourage more employee ownership. The idea was revived in discussions with the Center for American Progress for a 2015 report it issued on employee ownership and then championed by Senator Bernie Sanders (I-VT) and Joe Courtney (D-CT) in the House.

WORK Act Directs DOL to Develop ESOP Valuation Standards

Section (c)(4)(B) of the WORK Act requires the DOL 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.

Other Secure 2.0 Act Provisions Affecting ESOPs and Related Plans

In addition to the beneficial changes for employee ownership in the WORK Act, SECURE 2.0 makes many changes that will affect most ESOP plan sponsors and qualified plan sponsors in general. Some of these have to do with operational rules, others only apply to 401(k) plans, and still others provide additional small credits for that any sponsor of a defined contribution plan with under 100 employees can use. Plan sponsors need to learn what these changes are and discuss them with their plan advisors and their accountant to make sure they comply with and take advantage of the provisions that apply to them.

10% Tax Deferral for S Corporation Sellers Starting in 2028

Under Section 1042 of the Internal Revenue Code, an owner of stock in a non-publicly traded C corporation who sells to an ESOP that owns 30% or more of the stock after the sale can defer capital gains tax by reinvesting in stocks and bonds of U.S. operating companies. For many years, advocates have urged Congress to extend this to owners of S corporations. Section 114 of the SECURE 2.0 Act amends Section 1042 to allow these sellers the same benefit but with a limit of 10% of the amount realized on the sale for purposes of determining the amount of gain. So if an owner has $3 million in gain, $300,000 could be deferred. The new rules apply to sales after December 31, 2027.

While this is a very small win for ESOPs, having this in the law may make it easier for a future tax bill to expand this percentage.

Change in Definition of “Publicly Traded” for Certain Purposes

Section 123 of the SECURE 2.0 Act is confusing. It amends the diversification provisions of Internal Revenue Code Section 401(a)(35), effective for plan years beginning after December 31, 2027, to provide that in the case of an ESOP, an employer security will be treated as “publicly traded” for diversification purposes if it is subject to priced quotations by at least four dealers on an SEC-regulated interdealer quotation system, is not a penny stock, is not issued by a shell company, and has a public float of at least 10% of outstanding shares. Domestic issuers must publish audited financial statements at least annually, and foreign issuers have additional requirements. ESOP diversification requirements, do not speak to this issue at all, so it is not clear what the purpose of this would be.

The Senate Finance Committee's December 2022 summary of the SECURE 2.0 Act does not limit this to diversification but rather refers to general ESOP rules on whether a security is publicly traded. (Section 401(a)(35) concerns diversification, whereas Section 401(a)(28)(C) contains the independent appraiser requirement for employer securities not readily tradable on an established securities market.) This kind of change could, for instance, mean that some thinly traded shares on community banks with ESOPs would now not need a valuation. The reference to Section 401(a)(35) in the language that was enacted is likely a drafting error that will need correction, which would eliminate the annual independent appraisal requirement for companies covered by the language. That would need to be addressed in a technical corrections bill in the next Congress.

Cash-Out Threshold Increases from $5,000 to $7,000 After 2023

Section 304 of the SECURE 2.0 Act changes the upper limit for mandatory cash-outs that a plan may establish from $5,000 to $7,000 for distributions made after December 31, 2023.

Retirement Plan Overpayments

A potentially vexing issue for plan sponsors is what happens when an administrative error causes an overpayment to employees getting a distribution. If the company pays, is this harmful to existing participants? Does the company have to try to get the money back? Section 301 of the SECURE 2.0 Act now allows flexibility on this, no longer requires the overpayments be recouped, and allows certain overpayments to be treated as eligible distributions for rollover purposes.

Expansion of Employee Plans Compliance Resolution System (EPCRS)

Section 305 of the SECURE 2.0 Act now allows self-correction under the Employee Plans Compliance Resolution System (EPCRS) of any inadvertent compliance failure no matter when it occurred and regardless of its degree unless (1) the IRS identified the failure before actions were taken to correct it, or (2) the self-correction is not completed within a reasonable period.

Small-Company Retirement Plan Startup Credit Increase

Currently, if a company has no more than 100 employees and, in the three years before the first year a new retirement plan is in place, the company did not have an existing plan covering substantially the same people, it could claim a retirement plan startup credit of up to 50% of administrative costs, not to exceed a credit of $5,000 per year. Section 102 of the SECURE 2.0 Act now increases the credit to up to 100% of administrative costs for companies with no more than 50 employees. It also provides an additional per-employee credit for five years that is progressively reduced year by year and is gradually phased out for company sizes of more than 50 employees, up to the limit of 100 employees. The new rules apply to taxable years beginning after December 31, 2022.

Required Minimum Distribution Age Increased

Previously, required minimum distributions (RMDs) had to start at 72 (the SECURE Act of 2019 changed it from 70½). Under Section 107 of the SECURE 2.0 Act, this increases to 73 for those who attain age 72 after December 31, 2022, and age 73 before January 1, 2033. It increases to 75 for those who attain age 74 after December 31, 2032.

Military Spouse Retirement Plan Eligibility Credit for Small Employers

Section 112 of the SECURE 2.0 Act creates a new tax credit for employers with 100 or fewer employees who employ military spouses and make them eligible for defined contribution plans within two months after hire, make them eligible at that time for any employer contributions that employees would otherwise receive at two years of service, and immediately 100% vest the military spouse in all employer contributions. The tax credit equals $200 per military spouse plus 100% of all employer contributions up to $300, for a $500 maximum credit per spouse. The credit applies for three years and is limited to non-highly compensated employees. This provision is effective immediately after enactment.

Automatic Enrollment Now Required for New 401(k) Plans

Under Section 101 of the SECURE 2.0 Act, companies that sponsor a new 401(k) plan (and schools and tax-exempt organizations sponsoring new 403(b) plans) must automatically enroll participants upon becoming eligible. The employer must set a default employee contribution rate of at least 3% but not more than 10% (which the participant may opt out of or increase), with an automatic escalator of 1% per year up to at least 10% but not more than 15%. There are exceptions for new businesses that have been in existence for less than three years, small businesses employing no more than 10 employees, and governmental or church plans. Existing plans established before the enactment of the SECURE 2.0 Act are exempted entirely from the new auto-enrollment rule, except when a multiple employer plan is adopted after enactment. The new rules are effective for plan years beginning after December 31, 2024.

Penalty-Free Withdrawals for Emergency Expenses

Under Section 115 of the SECURE 2.0 Act, an employee can make one emergency withdrawal per year of up to $1,000 from a retirement account (such as a 401(k) plan or IRA) and not pay the 10% penalty tax on early distributions. (Although this technically applies to ESOPs too, ESOP almost never allow withdrawals like this.) The participant has the opportunity to repay the withdrawal during the following three years. During this three-year period, no further emergency withdrawals may be made unless the participant fully repays the amount or subsequent deferrals and contributions are at least equal to the amount of the previous withdrawal. The new rules apply to distributions made after December 31, 2023.

Reduced Waiting Time for Part-Time Workers to Participate in 401(k) Plans

The original SECURE Act of 2019 required 401(k) plans to allow “long-term, part-time workers,” defined as those who did not meet the 1,000-hours-in-a-year rule but instead had worked at least 500 hours per year for three consecutive years, to make elective deferrals to the 401(k) plan. (Employees covered by collective bargaining agreements are exempted from the requirement.) Section 125 of the SECURE 2.0 Act reduces this three-year period to two years, effective for plan years beginning after December 31, 2024. It also extends the 500 hour/two-year rule to 403(b) plans.

Higher Catch-Up Limits at Age 60, 61, 62, and 63

Currently, employees aged 50 or order can make additional “catch-up” contributions to eligible plans such as 401(k)s in an amount that is subject to adjustment yearly for the cost of living. The catch-up amount for 2022 was $6,500, and for 2023 it will be $7,500 (except for SIMPLE plans, for which it is lower). Section 109 of the SECURE 2.0 Act increases the catch-up limit, for taxable years beginning after December 31, 2024, to the greater of $10,000 or 150% of the standard catch-up amount for that year, but only for employees who attain the age of 60, 61, 62, or 63 during the taxable year. (SIMPLE plans get a similar increase but again with lower limits: $5,000 or 150%.)