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The Employee Ownership Update

Corey Rosen

August 1, 1997

(Corey Rosen)

Taxpayer Relief Act of 1997 Affects ESOPs, 401(k) Plans

The Taxpayer Relief Act of 1997 (the "Act"), reported on in the previous installment of this column and now about to be signed into law, contains provisions affecting employee ownership plans. The most important of these provisions makes employee stock ownership plans (ESOPs) more practical in S corporations, but other provisions affect ESOP estate planning issues and 401(k) plans.

The text of the ESOP and 401(k) provisions, as well as the other tax changes, can be found on the World Wide Web at http://thomas.loc.gov/. Search under "Bill Text" for "105th Congress" for bill number "H.R. 2014."

Note on August 11: President Clinton signed the bill on Tuesday, August 5. He had until Monday, August 11, to exercise his line-item veto power. When August 11 came, none of the employee ownership-related provisions were the subject of the President's line-item vetos.

Subchapter S Reform

The Act corrects a number of defects in the 1996 tax act's provisions concerning subchapter S corporations and ESOPs. The previous law allowed employee benefit plan trusts to hold stock in an S corporation starting in 1998, but, as structured, made it impractical to do so. The new law fixes these problems, but retains the old law's exclusion of S corporation ESOPs from a number of special ESOP tax benefits. The changes are effective in 1998.

Under the new law, ESOPs in S corporations can now require employees to take the cash value of their plan distribution rather than the stock itself. This is a critical change because the holding of company shares by departed employees could cause the company to lose its S status in some cases, such as if the employee puts the stock into an IRA (an IRA is not a qualified S corporation owner). The Act also exempts from the prohibited transaction rules of the Internal Revenue Code and ERISA sales of stock to an ESOP (but not to other qualified plans), as well as loans to an ESOP, by 5% shareholder-employees or the company. As the law was written in 1996, such sales or loans could expose fiduciaries and other parties to the transaction to liabilities and penalties.

Perhaps most important, the Act repeals the 1996 provision requiring ESOPs to pay unrelated business interest taxes (UBIT) on their share of S corporation earnings. Without this change, the trust could have been held responsible (presumably by using corporate contributions and cash dividends) for taxes both on its allocated share of earnings from annual S corporation profits and on any gains realized from the sale or distribution of stock. There had been an effort to extend this UBIT exemption to profit sharing plans, stock bonus plans, and 401(k) plans, but the Act limits it to ESOPs.

However, the Act does not provide S corporation ESOPs with the special ESOP tax benefits available to C corporations, including the deductibility of dividends used to repay ESOP loans or passed through to ESOP participants, section 1042 rollover treatment, or the higher contribution limits for leveraged ESOPs.

While this is a disappointment to ESOP advocates, some of these tax benefits are not as critical for S corporations, particularly the section 1042 provisions. Many S corporation owners have a substantially stepped-up basis when they sell because of taxes they have already paid on distributed earnings. The new law will not result in a flood of new ESOPs (most S corporations who wanted to set up an ESOP simply switched to C status in the past), but its impact should be noticeable nonetheless.

The language of the Act is notable in that the changes are specifically for ESOPs. Subchapter S corporations wishing to use other employee benefit plans to own employer stock will still find they face technical problems that will almost invariably make it impractical to do so. Practically speaking, this means S corporations who want to share ownership will have to comply with the additional protections ESOPs provide for employee owners, such as annual valuations and minimal voting rights.

ESOP Estate Tax Bill Passed

Congress sometimes passes legislation that appears to be general in scope, but really is meant mostly for a single company. In this case, Congress passed as part of the Act a provision allowing an ESOP to act as a charitable trust for an estate, provided the plan was in existence August 1, 1996, the decedent and members of the decedent's family own not more than 10% of the value of the company stock, and the ESOP owns at least 60% of the stock after the transfer. There were additional restrictions as well, including full voting rights for participants and an independent trustee. The provision was initiated by the Sammons Enterprises, Inc., a Texas-based company with an ESOP.

401(k) Diversification Rules Passed

The Act includes language that prohibits sponsors of 401(k) plans from requiring employees to invest in employer stock if the employee deferral part of the plan is 10% or more invested in company stock. The employer contribution part can be entirely in stock, however.

The provision has a specific exclusion for 401(k)/ESOP combinations. These plans can require employees to invest in employer stock, something very few do and, investment advisors would argue, is not a good policy. Stock bonus plans or profit sharing plans that are combined with a 401(k) plan would not receive the exemption.

The new law will have minimal practical impact and is greatly pared down from its original design, which would have required considerably more diversification. The impetus for the change was the disastrous experience of employees in companies such as Carter Hawley Hale, which required employees to invest in company stock and subsequently went bankrupt.

Author biography and other columns in this series

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