The Employee Ownership Update
August 12, 1996
New Tax Bill Includes Significant Changes for Employee OwnershipThe "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:
- Changes in ESOP law: S corporations will now be able to have ESOPs and other qualified plans as stock owners, although restrictions on ESOPs will provide them with fewer tax benefits than C corporations. The bill also eliminates section 133 of the Internal Revenue Code, the provision of the law allowing lenders to deduct 50% of the interest income they receive on ESOP loans provided certain requirements are met.
- Simplification of various plan rules, including the definition of highly compensated employees and the anti-discrimination provisions for 401(k) plans.
- Elimination of certain restrictions on how much can be contributed to qualified plans, including the repeal of family aggregation rules; allowing pretax employee deferrals to 401(k) and cafeteria plans to be included in calculating eligible pay for annual addition limitations; and the removal of the requirement to aggregate defined benefit and defined contribution plans when testing for annual contribution limits.
S Corporation Changes: ESOPs Allowed, but with RestrictionsUnder 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.
- Sellers to an ESOP cannot take advantage of the section 1042 rollover provision allowing the deferral of taxation when the sale proceeds are reinvested in other securities.
- Dividends used to repay an ESOP loan or passed through to participants are not tax deductible.
- The maximum contribution level for an ESOP, leveraged or non-leveraged, is 15% of eligible pay, whereas C corporations can contribute 15% to a non-leveraged ESOP but 25% to a leveraged ESOP. However, 25% of pay can be contributed in an S corporation if the ESOP includes a money purchase pension plan (just as with a non-leveraged ESOP in a C corporation).
- When calculating the amount contributed to the plan for testing against annual section 415 contribution limits, interest payments on an ESOP loan must be included. In C corporations, only principal payments count. This will further lower the maximum contribution level in S corporations' leveraged ESOPs by about a third in typical cases.
- The ESOP is taxable on any gains made when it disposes of stock, possibly including distributions to employees.
Section 133 (the ESOP Lender Interest Exclusion) to Be RepealedSection 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.
- Highly Compensated Employees: The current definition of a highly compensated employee is very complex. The new definition, effective for plan years starting after December 31, 1996, is simple: a 5% owner at any time during the preceding year or an employee whose compensation for the preceding year was $80,000 or more, to be indexed for inflation. This provision is effective on enactment.
- Section 401(k) Changes: The 401(k) changes are more sweeping. Current law requires that 401(k) plans meet rules specifying that the average percentage of pay deferred by highly compensated employees cannot be more than 1.25 times the average percentage of everyone else. This ratio can be as high as two, however, if the absolute difference among the two groups is less than 2% (that is, 4% to 2% would work, but 6% to 3% would not). Effective for plan years starting after December 31, 1998, the new bill provides alternatives to meet these tests through company matching contributions. To simplify somewhat, a company can qualify its plan even if the above tests are not met through one of the following two methods:
The importance of this provision for employee ownership purposes is simply that many companies may now decide to enhance their match to qualify their plans and let highly compensated employees contribute more than under current law. One way to do this would be to combine an ESOP with a 401(k) plan and use stock contributions for the match, or simply to contribute company stock as the match.
- It matches employee elective deferrals at 100% up to at least 3% of pay and matches at 50% at least for contributions between 3% and 5%. The matching contribution rate cannot be higher for highly compensated employees than for other employees.
- The employer makes a contribution to all eligible participants, whether they make an elective deferral or not, of at least 3% of pay.
Easing of Restrictions on How Much Can Be Contributed to Employee Benefit PlansThe 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.
- Employee elective deferrals will count as eligible compensation: Under existing law, elective pretax employee contributions to 401(k) plans and cafeteria plans could not be counted as eligible compensation for total contribution limits. Thus, a $30,000/yr. employee contributing $1,000 to a 401(k) plan and $500 to a cafeteria plan was considered to have $28,500 in eligible compensation. Total 401(k)/ESOP contributions, for instance, could then not exceed 25% of $28,500. Under the new law, these deferrals will count as eligible pay, and the entire $30,000 will be eligible. The new law is applicable for plan years starting after December 31, 1997.
- Family attribution rules are eliminated: Under existing law, the compensation of a spouse or lineal descendant covered by the same plan was considered compensation for the other spouse or the parent. A husband and wife each making $80,000 were thus considered to be making $160,000. This could limit the amount they could receive in annual contributions due to the $150,000 limit on compensation eligible for contributions. This rule is now repealed for plan years starting after December 31, 1996.
- Aggregation of defined benefit and contribution plan limits repealed: Under existing law, if a company maintains both a defined benefit plan and a defined contribution plan, it must use a formula to calculate an amount that will be considered an annual addition for the purposes of its defined benefit plan. It must then add that to what it contributes to its defined contribution plans to determine if it exceeds the maximum annual contribution limits. Effective for plan years starting after December 31, 1999, this law is repealed and the two do not need to be aggregated.
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