ESOPs and the Tax Act

On December 22, 2017, the Tax Cuts and Jobs Act was signed into law, resulting in significant changes to the treatment of corporate taxes. The most significant facet of the Tax Act was the reduction in federal income taxes for C Corporations from a top marginal tax rate of 39 percent to a flat 21 percent tax cut.

In January 2018, at a White House briefing President Trump was seen surrounded by employees of businesses, eager to tell him how their companies are benefiting from the reduced tax structure as a result of the Tax Act. Employee Stock Ownership Plan (ESOP) professionals can’t help but parallel this scene to the experiences of companies that have sold to an ESOP. The parallel here pertains to “the taxes” part of an ESOP. (Note: A sale of a company to an ESOP is similar to a management buyout, except that the ESOP (instead of management) will buy either all or a portion of the company from selling shareholders, and the employees will eventually be owners of that stock.) There is euphoria over new tax breaks for C Corporations. The irony is that the tax benefits have been significant for many ESOP companies for decades. Explicitly, if a company is an S Corporation, taxes are passed through to its shareholders and under circumstances defined below, an S Corporation could conceivably (and often does) pay zero income taxes on its taxable income. The additional benefits of being an ESOP are gravy to this significant tax benefit to the company, the exiting shareholders and its employees.

As a quick refresher, an ESOP is a defined contribution plan, which is a particular form of a retirement plan as defined by the IRS. As a retirement plan, an ESOP (or, more specifically, the trust that holds it) is a tax-exempt entity. If the company is an S Corporation, the company pays zero income taxes on the proportional shares owned by the ESOP. If the ESOP owns 100 percent of the company stock, the company pays no income taxes. There are significant additional benefits to being an ESOP than just the S Corporation tax benefits, however, these factors are beyond the scope of this article.

To highlight the potential magnitude of this tax break for an S Corporation ESOP company, the chart below presents a comparison of three tax scenarios:

1. A non-ESOP company
2. An S Corporation, where the ESOP owns 50 percent of the corporation
3. An S Corporation, where the ESOP owns 100 percent of the corporation

Additional Cash Flow to Company for Being an ESOP
	Scenario A	Scenario B	Scenario C
	S Corp Net Income Of $5,000,000 No ESOP	S Corp Net Income Of $5,000,000 50% ESOP	S Corp Net Income Of $5,000,000 $100% ESOP
Taxable income (based on % ESOP owns)	$5,000,000	$2,500,000	$0
Corporate Tax	$0	$0	$0
Individual Shareholder’s Tax rate (1)	37%	37%	37%
Total “Tax Dividend”	$1,850,000	$925,000	$0
ESOP Shareholder Tax on $2,500,000		$0	No Tax Dividend -  Company chooses how to best utilize tax savings
ESOP Share of Tax Dividend		$925,000
(1)  The Individual Tax Rate assumes the highest marginal rate, beginning in calendar year 2018, per the Tax Act. This simplified chart does not detail deductions or other items that might affect total taxable income.

 

Various Scenarios Can Show The Impact On Cash Flow

We can establish three scenarios that model the additional cash flow to a company for being an ESOP. Let’s assume in each scenario the company is an S Corporation with net income of $5,000,000. In each scenario, the individual tax rate assumes the highest marginal rate, beginning in calendar year 2018, per the Tax Act. These scenarios are simplified and do not detail deductions or other items that might affect total taxable income.

• Under Scenario A, the company has no ESOP ownership so its taxable income (based on % of ESOP ownership) is $5,000,000, $0 in corporate tax and an individual shareholder tax rate of 37 percent. In this case, the company pays $1,850,000 in taxes at the shareholder level, and thus the company must pay a “Tax Dividend” to fund that tax payment.
• Under Scenario B, the company has a 50 percent ESOP ownership therefore its taxable income is $2,500,000, $0 in corporate tax and an individual shareholder tax rate of 37 percent. The company needs to make a “Tax Dividend” of $925,000 to the 50 percent non-ESOP shareholder (to fund taxes). The company also needs to match that pro rata and make a dividend payment of an additional $925,000 to the ESOP (thus, still making a total of $1,850,000 payments (50 percent for taxes, 50 percent mandated payment to ESOP, even though the ESOP pays no taxes)).
• Under Scenario C, the company is owned 100 percent by the ESOP, a tax-exempt entity and pays no tax dividend – so they are able to choose how to best utilize their tax savings. The company has an additional $1,850,000 in cash flow for other purposes (capital investments, debt pay-down, bonuses, etc.)

Why are we focusing on the tax savings of an S Corporation, when the title of this article is the major benefits of a 21 percent flat income tax rate to C Corporations under the Tax Act? Because the tax benefits for ESOP-owned companies are significantly greater for S Corporations, going from a 37 percent potential tax rate (prior to consideration of a pass-through entity’s potential standard deductions) to zero percent taxes, than they are for C Corporations, going from a 39 percent tax rate to a 21 percent tax rate. The enthusiasm trumpeted by American taxpayers is the same enthusiasm about the tax structure that management and employees have been exuberantly discussing with their newly formed ESOPs throughout the country for decades.

There are expectations and newly formed promises of what C Corporations now hope to do with this new found cash. In our experience, what have we seen companies doing with their excess cash flow for 100 percent ESOP companies? With their newfound cash flows, we have seen operational changes by ESOP-owned companies such as:

• Pay-down of existing debt
• Accelerate payment of new debt vehicles
• Reinvest in capital equipment
• Invest in state of the art technology
• Build their building, instead of paying rent to a third-party
• Make acquisitions to strategically grow their business
• Make key hires to organically grow their business
• Create a sinking fund to pay out retirement benefits to ESOP shareholders, when it is time to redeem their company stock

What Other Factors Does This Tax-Savings Drive In ESOP Companies?

• 100 Percent ESOP Transactions – The “biggest bang” for S Corporation ESOPs comes when 100 percent of the corporate stock is owned by the ESOP. Thus, while shareholders have the option to sell a fraction of their business to the ESOP, it is increasingly prevalent for transactions to go from 0 percent ESOP (pre-ESOP) to 100 percent ESOP, as part of the initial transaction. While there are other factors at play (owner not ready to sell 100 percent of the business, management not prepared to operate without the founding shareholder, etc.), the economics of an ESOP is maximized by being 100 percent ESOP-owned. Many factors are contemplated and analyzed, using various scenario analyses, under a 100 percent ESOP sale transaction. However, a mature team of ESOP professionals are familiar with the terms of this deal and the required financing, and other management perks necessary, to make this happen.
• Increased Bank Debt in ESOP Transaction – A 100 percent ESOP transaction often involves a higher transaction price than the company may have initially contemplated. The most economically prudent decision to fund this transaction is to finance the deal with third-party debt. It is very common to see transactions financed (from various sources) with 100 percent debt. The senior debt is typically financed with a commercial bank (typical loan from a commercial lender, based on the cash flows of the company), that may be willing to lend up to three to four times EBITDA. The commercial banks tend to view ESOPs favorably because they have excess cash flow, which translates into a substantial level of available cash flow for structured principal and interest payments.
• Increase Use of Subordinated Notes in the Transaction – The debt capacity from senior debt lenders is typically insufficient to finance the transaction. Thus, the selling shareholder is willing to take back a subordinated note (as opposed to cash), and delay the remainder of their payout for many years (anywhere from seven to 15 years could be seen as a reasonable range for a “Seller’s Note” payback terms). The bank considers the Seller’s Note as “friendly debt” as it is subordinate to the Senior Debt and it has equity-like features. Seller’s Notes have become ubiquitous with 100 percent ESOP transactions.

Taxes are supposed to be a permanent aspect of business life. Benjamin Franklin once said that “the only things certain in life are death and taxes.” While the former, at least to date, appears to be a truism, a properly and tax-efficient structured sale of company stock to an ESOP can potentially make the “taxes” portion of that quote certain, as in certainty of no (federal income) taxes. The focus of this article is clearly on the beneficial tax treatment for specific ESOP companies. There are so many other reasons that selling shareholders, corporate executives and their employee base loves their ESOPs.

In summary, ESOPs should be considered in every discussion with attorneys, accountants, appraisers and other company advisors about succession planning. Too few business owners and advisors explore this option. Hopefully, as all parties become increasingly aware of the benefits of ESOPs as a succession planning option, the popularity of ESOPs will become even more ubiquitous in America. This historic reduction in taxes as a result of the Tax Act, and the buzz it is creating in corporations and by employees across America, should be a glaring reminder of this type of company structure, with zero taxes, that is available for many companies who have the right criteria (broadly and subjectively defined as (i) strong post-transaction management, (ii) strong/stable earnings and (iii) debt capacity) for being an ESOP-owned company.

 

Patrice Radogna, ASA, CBA, CPA, ABAR is senior vice president of VRC.