CRS Reports on ESOPs, S Corporations

                       CRS REPORT FOR CONGRESS

[1] Employee Stock Ownership Plans (ESOPs) are tax-favored retirement plans that are required to invest primarily in the sponsoring employer's stock. Employees are not taxed on their share of ESOP earning until the funds are actually distributed. S corporations are closely-held corporations that are not subject to the corporate income tax. Income earned through an ESOP associated with an S-corporation (an S-ESOP) is thus both exempt from corporate level tax and tax-deferred under the individual income tax. In 1999, the Clinton Administration proposed raising taxes on S-ESOPs by applying the Unrelated Business Income Tax (UBIT) to S-ESOP income. Congress did not act on the Administration's proposal, but included more narrow S-ESOP restrictions in a broad tax cut bill (the Taxpayer Refund and Relief Act; TRRA) that it passed in August, 1999. The President vetoed the TRRA for reasons not directly related to S- ESOPs. In 2000, S-ESOPs continue to receive the attention of the Administration and Congress. The Administration's fiscal year (FY) 2001 budget contained a narrower version of its earlier proposal. In Congress, H.R. 3082 (Rep. Ramstad) and S. 1732 (Sen. Breaux) were introduced; both are based on the S-ESOP proposal contained in the TRRA. In July, 2000, the House passed H.R. 1102, a pension reform measure. The S-ESOP plan that was in the TRRA and subsequently proposed in H.R. 3082 and S. 1732 was included in the bill. This report will be updated as legislative events occur.

BACKGROUND ON ESOPs

[2] The Internal Revenue Code's ESOP provisions were first enacted with the Employee Retirement Income Security Act of 1974 (ERISA). ¹ Their purpose was to broaden employee stock ownership, to provide employees with a source of retirement income, and to afford firms a tax-favored source of financing. Despite their tax advantages ESOPs are not a large presence in the economy. According to the most recent estimates published by the National Center for Employee Ownership (NCEO), in 1995 ESOPs owned $226 billion of corporate stock -- 3.7% of the estimated $6.1 trillion of total corporate equity. ² An estimated 8.3 million employees participated in ESOPs -- about 6.3% of the labor force. ³

[3] In the years since ERISA, the precise set of tax benefits available to ESOPs has varied, with the range of tax benefits initially being expanded, subsequently scaled back, only to be expanded in other ways. The heart of the ESOP tax benefit, however, remains the same under current law as it was enacted with ERISA: a deferral (postponement) of employee income taxes on income earned through an ESOP. As with other qualified pension plans, the basic deferral works as follows: employer contributions to ESOPs are tax deductible like other forms of employee compensation. This deduction in itself is not a tax benefit, and simply allows the deduction of labor expense from a firm's taxable profit. The deferral occurs because ESOPs themselves are exempt from tax; employee participants are not taxed on income earned through an ESOP until it is actually received as a pension distribution. The tax deferral applies both to the initial employer deposits in an ESOP and the investment earnings that accrue on the deposits (chiefly earnings on employer stock).

[4] ESOPs are similar to other tax-favored employer-sponsored pension plans in their postponement of taxes until retirement. However, unlike other tax-qualified pension plans, ESOPs are required to hold most of their assets in the form of employer stock. Also, ESOPs are permitted to borrow to finance purchases of employer stock.

S CORPORATIONS

[5] As noted in the above summary, current proposals would apply to ESOPs associated with a specially defined type of corporation known as an "S" corporation. Normally, corporations are subject to the corporate income tax. However, if relatively closely- held corporations meet certain requirements and make an election under Subchapter S of the Internal Revenue Code, the Code exempts them from the corporate income tax. Profits earned by these S corporations are allocated on a pro-rata basis among the firm's shareholders and included in the shareholders' taxable income in the year they are earned. The most important requirement for S corporations is that they have no more than 75 shareholders. (Taxable firms that do not meet these requirements are generally referred to as "C" corporations.)

[6] But S corporations aside, corporate profits are ordinarily subject to tax at rates that range up to 35%. Further, corporate sector income is normally subject to an additional, second level of tax under the individual income tax. This occurs when corporate profits are transmitted to individual stockholders as either taxable dividends or capital gains. ⁴ For tax analysts, this "double taxation" of corporate income is one of the central structural features of the way federal taxes apply to corporate-source income.

[7] The tax code's S-corporation provisions thus eliminate one of the two layers of tax that ordinarily apply to corporate source income -- they were enacted in 1958 so as to permit businesses "to select the form of business organization desired, without the necessity of taking into account major differences in tax consequence." ⁵ At issue with S-ESOPs is whether the preferential tax treatment of S-corporations compared to C-corporations should be preserved in the ESOP setting where the second level of tax -- the individual income tax -- is imposed on a deferred basis.

TAX BURDEN ON S-ESOPs AND OTHER RETIREMENT SAVINGS VEHICLES: CURRENT LAW

[8] The policy issues presented by S-ESOPs can be seen more clearly by comparing the tax burden on S-ESOPs under current law with the burden on other retirement savings vehicles, including other ESOPs and traditional Individual Retirement Accounts (IRAs). First, S-ESOPs: as described above, corporate level taxes do not apply to S- corporations. Thus, no more than one layer of tax -- the individual income tax -- applies to S-ESOPs. But that single remaining level of tax is itself applied only on a deferred basis: neither the initial deposit in the ESOP nor earnings on that deposit are taxed until they are distributed. Because of discounting -- the basic economic principle that economic actors value a given amount of resources more the sooner they receive it (or value a payment of a given amount less, the longer they can postpone it) -- the ESOP tax deferral confers a tax benefit. And when the benefit is taken into account, the single, individual level of tax that applies to S-ESOPs applies only on a reduced basis.

[9] Next, ESOPs associated with C corporations (C-ESOPs). As with S-ESOPs, employees are not subject to tax on amounts contributed to ESOPs or an ESOP's earnings until they are distributed. Thus, the individual level of tax again applies only on a reduced basis. However, in contrast to S-ESOPs, earnings on the stock the C-ESOP owns are paid out of profits subject to the corporate income tax in the hands of the C-corporation/employer. Thus, C-ESOP income is subject to two levels of tax: one full level of tax at the corporate level, and one reduced layer of tax at the individual level.

[10] We can get a general idea of the size of the S-ESOP and C- ESOP tax benefits by comparing them with the widely-used IRA retirement savings vehicle. The tax burden on the more lightly-taxed S-ESOPs is similar to that of traditional IRAs as long as we assume the IRA's investments are not in C-corporation stock. The tax code's IRA rules permit qualified individuals to deduct up to $2,000 in annual contributions to IRAs. As with ESOPs, neither the original deposits nor the deposit's investment earnings are subject to tax until the funds are withdrawn. Further, the tax savings from deducting IRA deposits is the equivalent in tax-savings terms of an employee not paying tax on amounts that an employer contributes to an ESOP. In fact, as long as an IRA's investments are not in stock subject to the corporate income tax, retirement saving through S- ESOPs faces the same tax burden as saving through IRAs. However, in cases where an IRA invests in corporate stock whose earnings are reduced by the corporate income tax, IRAs bear the same tax burden as C-ESOPs.

[11] The chart below provides a schematic illustration of where S-ESOP taxation fits into the federal tax structure under current law. Comparison of the entries in the two non-ESOP columns (columns 1 and 2) with those in the ESOP columns (columns 3 and 4) illustrates that under current law, the relative position of S corporations and C corporations is the same in either the ESOP or non-ESOP setting: S corporation income is more favorably taxed.

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[12] Prior to enactment of the Small Business Job Protection Act of 1996 (Public Law 104-188), S corporations were not permitted to have ESOPs or certain other tax-exempt entities as shareholders. The 1996 Act removed the prohibition on ESOP ownership, but also applied the Unrelated Business Income Tax (UBIT) to an ESOP's share of S-corporation earnings. The Act also denied to S-corporation S- ESOPs the capital gains deferral and dividend deduction benefits available to other ESOPs. The Act's provisions were scheduled to be effective beginning in 1998.

[13] The application of UBIT to S-ESOPs more than offset the tax deferral an ESOP normally provides, and would have made S-ESOPs relatively unattractive. ⁶ In 1997, however, the Taxpayer Relief Act of 1997 (Public Law 105-34) repealed the application of UBIT for S-ESOPs' share of S-corporation income.

[14] PROPOSALS IN 1999. The Administration's FY2000 budget proposal argued that the 1997 UBIT repeal went too far. Business income, the Administration argued, should be subject to at least a single level of tax on a current basis rather than the single, deferred, level of tax applied to S-ESOPs without the UBIT.

[15] The Administration's proposal, however, stopped short of full application of the UBIT. The plan worked as follows: UBIT would apply on a current basis to an S-ESOP's earnings on its employer stock and other investments. However, when an S-ESOP distributes earnings to plan participants, the distributions would be deductible from the S-ESOP's taxable income. In effect, the UBIT would apply only on a temporary basis, somewhat like a reverse tax-deferral.

[16] The burden of the proposed UBIT would vary, depending on an S-ESOP's circumstances and the length of time between an employer's contribution to the S-ESOP and its distribution to the employee. (Generally, the shorter this time period, the lower the burden.) CRS estimates elsewhere suggest that the ability of an S- ESOP ultimately to deduct distributions would offset a substantial portion of the UBIT's burden, despite the fact that time elapses between payment of the UBIT and the claiming of the deduction. In fact, the only burden imposed by the UBIT coupled with the deduction is loss of control over the UBIT funds for a limited period of time. The burden of the proposal on most S-ESOPs would still likely be substantially less than the tax burden faced by C-ESOPs. ⁷ According to Joint Tax Committee estimates, the proposal would have increased revenue by $272 million over 5 years.

[17] The Administration's proposal in the FY2000 budget would have applied to all S-ESOPs. On August 5, 1999, Congress passed the Taxpayer Refund and Relief Act of 1999 (TRRA), a broad tax bill that included a more narrow approach to S-ESOPs than proposed by the Administration. Rather than imposing UBIT on all S-ESOPs, the bill would inhibit formation of S-ESOPs that have particular features -- features thought to be most likely to lead to use of the entities as tax shelters for their owners rather than tools for increasing ownership and productivity among rank-and-file employees. ⁸ One such situation, for example, might be where an S corporation is controlled by only a few people who are also the principal ESOP participants.

[18] More specifically, the bill imposes prohibitively high penalties on employers who make certain contributions to their ESOPs in certain circumstances. The penalty is an excise tax equal to 50% of the "prohibited" allocation (contribution); the contribution in question is further treated as having been distributed to the participant and is thus also taxed in the hands of the participant.

[19] The penalties would apply in any year (termed a "nonallocation year") if at any time during the year persons who own large blocks of the ESOP's stock -- "disqualified persons" under the bill -- own 50% or more of the corporation itself. An individual would be such a disqualified person if their portion of stock owned through the ESOP is least 10% of the total number of shares of the corporation's stock that are outstanding, or if the individual or the individual's family members own at least 20% of outstanding stock through the ESOP. In short, the bill would impose prohibitively high taxes on S-ESOPs where there is an overlap between the principal ESOP participants and the corporation's principal owners.

[20] The provision was estimated to produce a very small increase in tax revenues: $17 million over 5 years, according to the Joint Committee on Taxation. ⁹

[21] PROPOSALS IN 2000. The President's FY2001 budget that was proposed in February, 2000, again would have applied the UBIT/deduction regime to S-ESOPs. The new proposal, however, would apply to a narrower range of S-ESOPs than the previous year's plan, thus moving in the direction of [sic] TRRA proposal. In a manner similar to the TRRA, the Administration's new proposal attempts to distinguish between ESOP participation by rank-and-file employees and a corporation's principal owners.

[22] The particular way the distinction is made, however, differs from that in the TRRA. The plan would apply the UBIT only to S-ESOPs that are not "broadly based" under the terms of the proposal. An S-ESOP would not be broadly based if 10% or more of its balances are allocated to highly compensated employees or to persons owning more than 2% of the corporation's stock. A comparison of this 2% threshold to the TRRA's definition of "disqualified persons" as those owning 10% of stock through an ESOP suggests that the Administration's proposal would apply to a wider range of S-ESOPs. At the same time, however, where it does apply, the Administration's tax burden would likely not be as high as the TRRA's. According to Joint Tax Committee estimates, the proposal would increase revenue by $169 million over 5 years.

[23] Congress did not act on the President's proposal. Instead, a slightly modified version of the TRRA's proposal was included in H.R. 1102 -- a pension reform bill that was approved by the House on July 19, 2000. The new version of the proposal contains a definition of "synthetic equity" that is apparently designed to improve the administration of the plan. (Synthetic equity would generally be stock ownership disguised using stock options and other means; the same definition is contained in the Administration's FY2001 proposal.) The proposal is estimated by the Joint Tax Committee to increase revenue by $24 million over 5 years. The provision is also contained in a version of H.R. 1102 approved by the Senate Finance Committee on September 7, 2000.

² National Center for Employee Ownership. ESOPs, Stock Options, and 401(k) Plans Now Control 8.3% of Corporate Equity. Published at the NCEO website at http://www.nceo.org/

³ National Center for Employee Ownership. A Statistical Profile of Employee Ownership. Available at the NCEO website: http://www.nceo.org/library/eo_stat.html

⁴ In some cases, however, individual taxes do not apply. This is the case, for example, when non-taxable entities such as pension plans are stockholders or when stock is held until death and passed on to heirs.

⁵ U.S. Congress. Senate. Committee on Finance. Small Business Tax Revision Act of 1958. S.Rept. 85-1983. 85th Cong., 2d Sess. Washington, U.S. Govt. Print. Off., 1958. P. 1104.

⁶ Diamond, Louis. Post-TRA '97 Corps. and ESOPs -- An Ideal Combination. Tax Adviser. January, 1999. P. 46-52.

⁷ U.S. Library of Congress. Congressional Research Service. Taxation of S-Corporation Employee Stock Ownership Plans (ESOPs): Recent Proposals. CRS Report RL30325, by David L. Brumbaugh. Washington, 1999. P. 7-8.

⁸ See the dialogue between Assistant Secretary of the Treasury for Tax Policy Donald Lubick and Senator Breaux during the Finance Committee's hearings: U.S. Congress. Senate. Commitee on Finance. Revenue-Raising Proposals in the Administration's Fiscal Year 2000 Budget. Hearing before the Committee on Finance, United States Senate. 106th Cong., 1st Sess. Washington, U.S. Govt. Print. Off., 1999. P. 13-15.

⁹ These and other Joint Tax Committee estimates cited in this report can be found on the Committee's web page, at: [http://www.house.gov/jct/].