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The Employee Ownership Update

Corey Rosen

July 27, 2000

(Corey Rosen)

House-Passed Bill Benefits ESOPs, Eases Defined Contribution Plan Rules

The "Comprehensive Retirement Security and Pension Reform Act of 2000" (H.R. 4843), which passed the House by an overwhelming margin July 19th, allows ESOP dividends to be reinvested without the loss of the dividend deduction for the employer, creates rules for preventing abusive S corporation ESOPs, significantly eases the rules for 401(k) plans, eliminates to 25% of pay cap in defined contribution plans, changes the top-heavy rules, and makes a number of other important changes in defined contribution plans. The Senate may not have time to act on the bill this year, however, and President Clinton has said he will veto the bill in its current form, charging that it costs too much and provides most of its benefits to 5% of the taxpayers. The broad support for the bill in the House, however, suggests that some compromise on these issues is possible this year and likely in the next Congress if nothing passes this one.

ESOP Provisions

The bill would create special rules to prevent abusive S corporation ESOPs. The complicated provision essentially provides for severe taxation of amounts allocated to ESOP participants who are significant owners of the company. These "disqualified persons" are defined as those who 1) collectively own 50% or more of the company and either a) own 10% or more of the shares of the company or b) along with siblings, ascendants, and descendants, own more than 20% of the company. The shares owned include shares allocated in the ESOP, and a pro-rata portion of the unallocated shares. If an allocation is made to these persons in an allocation year, the individual is taxable on those amounts and the company must pay a 50% excise tax on them. In the first year, the tax applies to the fair market value of all the deemed owned shares of the disqualified individual, allocated in the ESOP or not.

Synthetic equity would not count for the deemed owned shares calculations. If synthetic equity ownership would make someone a disqualified individual, however, and that individual gets an allocation, there is a 50% excise tax on the amount of synthetic equity that individual owns.

These provisions will discourage many of the S corporation ESOPs where only a few people are benefiting. While experts caution there may still be ways to abuse the law, they send a clear message that Congress will likely address those as well if they come up.

Dividend Deductibility

The bill provides that employees can reinvest their ESOP dividends back into the plan by purchasing their employer's stock either directly or through a payroll agent. Unlike current law, the company would get a tax deduction for these reinvestments.

Increases in Contribution Limits

The bill provides for dramatic increases in plan contribution limits:

Other Provisions

Among a variety of other provisions, the law would also require faster vesting for plans with employer matching contributions to employee deferrals. Vesting would have to be completed in three years for cliff vesting and six years for graduated vesting. The proposal apparently would not apply to straight employer contributions, such as to an ESOP. The bill also increases the portability of assets in plans, eases top-heavy rules by repealing family attribution requirements and defining key employees as officers making over $150,000 per year, provides for higher "catch-up" contributions for employees over 50, and creates a variety of other provisions less directly relevant to ESOPs and similar plans.

More Information

For a complete explanation of the new bill, go to the Joint Committee on Taxation's very readable explanation of the plan's provisions.

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