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The Employee Ownership Update

Corey Rosen

August 12, 1996

(Corey Rosen)

New Tax Bill Includes Significant Changes for Employee Ownership

The "Back to Small Business Job Protection Act" (the small business tax incentives feature of the Minimum Wage Bill) contains a number of provisions important to employee ownership. The bill has now been passed by the Congress and should be signed in the next few weeks by the President. Note on August 28: The bill was signed into law on August 20; also, this column has been revised to better and more accurately describe the legislation and its implications for employee ownership.

There are three areas of significant change:

S Corporation Changes: ESOPs Allowed, but with Restrictions

Under current law, employee benefit trusts cannot own stock in an S corporation. The new law would change this, effective January 1, 1998, to allow ESOPs, profit sharing plans, stock bonus plans, and 401(k) plans to own stock in their companies. S corporations have the limited liability of a regular C corporation but do not pay tax. Instead, all earnings (income and capital gains) are attributed each year on a pro-rata basis to the company's owners. This applies whether or not the owners actually receive cash or the earnings simply show up on the company's income statement or balance sheet. This means corporate income is taxed at personal tax rates, and no corporate income is taxed twice (as would be the case for dividends paid to owners of a C corporation). The new law also increases the maximum number of shareholders allowed in an S corporation from 35 to 75.

If an S corporation were to have a non-taxable trust as an owner under current law, this would mean that any earnings passed on to the trust would not be taxed. As a result, S corporations were not allowed to have these trusts as owners. Under the new law, profit sharing plans, ESOPs, and 401(k) plans would be allowed to own stock in an S corporation, but they would be responsible for paying taxes on their share of the earnings at the trust's tax rate. Presumably, the corporation would pay these taxes by making contributions to the trusts. In some states, however, the trusts will not have to pay state taxes.

While S corporations can now have ESOPs, there are, however, four major restrictions on their tax benefits:

Because of the restrictions and problems, we anticipate very few S corporations will set up leveraged ESOPs to buy out owners. As is the case now, most will find it worthwhile to convert to C status. On the other hand, some S corporations may find it appealing to contribute their own stock to a profit sharing, stock bonus, or 401(k) plan. Cash contributions to a stock bonus plan, for instance, could be used to provide a tax-deductible way for owners to use corporate cash to buy their shares. Stock contributions to any 401(k) plan, profit sharing plan, non-leveraged ESOP, or stock bonus plan could be used to share ownership with employees at no up-front cash cost.

Section 133 (the ESOP Lender Interest Exclusion) to Be Repealed

Section 133 of the Internal Revenue Code allows lenders to exclude up to 50% of the interest income they receive on loans to ESOPs owning more than 50% of a company's shares. This provision is repealed by the new bill, effective when the President signs it. However, loans for which a binding commitment is in place as of June 10, 1996, but which have not actually been completed by the signature date, will be allowed.

This provision of the tax code has been used only rarely in recent years, so its elimination is not expected to have a significant impact.

Benefit Plan Simplification Changes (Highly Compensated Employees, 401(k) Participation Requirements)

The new bill makes a number of changes in employee benefit plan law intended to simplify plan operations. The two most significant concern the definition of highly compensated employees and the participation requirements for 401(k) plans.

Easing of Restrictions on How Much Can Be Contributed to Employee Benefit Plans

The new law makes a number of changes that will increase how much can be contributed to employee benefit plans, the most important of which are as follows.

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