The tax policy changes proposed by the Biden administration would roll back many of the tax benefits provided by the Tax Cuts and Jobs Act (TCJA) enacted at the end of 2017. The most significant proposals include increasing the federal corporate income tax rate to 28% from 21%, raising the top personal income tax rate from 37% back to the pre-TCJA rate of 39.6%, reducing the estate tax exemption threshold, thus bringing more estates within the scope of the federal estate tax, and almost doubling the capital gains tax rates on individuals earning $1 million annually, from 20% to 39.6%. The Biden administration is also considering a phase-out of the Qualified Business Income (QBI) deduction applicable to both pass-through entities and real estate investment trusts for those deriving income that exceeds a certain threshold ($400,000)—the QBI deduction currently allows eligible taxpayers to deduct up to 20% of pass-through income.
Of particular importance in the context of ESOPs, the Biden administration is considering the elimination of the current “step-up in basis” for inherited capital assets. Currently, a “step-up in basis” enables the heirs of a business owner to potentially avoid capital gains tax on the unrealized appreciation of capital assets that pass through the estate.
One of the most compelling reasons for a business owner to sell all or a portion of his/her business to an ESOP is the tax-free rollover provision in Internal Revenue Code (IRC) Section 1042. At a high level, Section 1042 allows an owner(s) of a C Corporation (C Corp) to defer or potentially eliminate capital gains tax on the sale of the company if they have held the shares for at least three years, sell at least 30% to an ESOP and the seller invests the sale proceeds in “Qualified Replacement Property” (QRP) within the prescribed timeframe (three months before or 12 months following the date of sale). If a Section 1042 rollover is executed correctly, the heir(s) will receive a step-up in basis upon the selling shareholder’s death and avoid paying capital gains tax on the original sale, as well as any possible appreciation in the QRP investment account.
Section 1042 is attractive to business owners, and the elimination or any significant change to the step-up in basis provisions could make certain ESOP transactions less tax advantageous to the selling shareholders. If capital gains tax rates are increased, and the shareholder believes that tax rates will be lower at some point in the future, Section 1042 could still be utilized to defer the capital gains tax on the replacement property until a more favorable tax rate environment presents itself or if the estate tax provision allowing for a step-up at death is reinstated.
The TCJA lowered the federal corporate income tax rate from 35% to 21%, and as noted above, under the Biden tax plan, the current rate would increase to 28%, which also could impact ESOPs. A tax rate increase is consequential for all companies since it will likely decrease the fair market value of the company at the time of sale as the after-tax cash flow decreases. Many valuations (ESOP or non-ESOP) use the discounted cash flow method as an input to the overall valuation of a business. Discounted cash flow analysis estimates the value of a business (or asset) based on its expected future cash flows. A higher corporate tax rate would result in lower cash flows and thus a lower valuation.
For a C Corp-owned ESOP, the decreased repurchase obligation may offset some of the negative impact on cash flow resulting from the increased federal tax rate. In most cases, the decline in the repurchase obligation will be offset by decreased cash flow as a result of the higher corporate rate.
In contrast, an S Corporation-owned ESOP will have a decreased repurchase obligation due to the lower valuation. Since the eventual tax obligation is passed through to the account holder, the increase in taxes would have a nominal impact. Therefore, the potential lower repurchase obligation would not be offset by an increase in tax rates, resulting in a true benefit to the company and a lower potential benefit for employees.
If the Biden tax proposals were to take effect, business owners may wish to consider a sale to an ESOP prior to enactment. In most—if not all ESOP transactions—the owner or owners will not achieve 100% liquidity at close, and as such, the IRS enables taxpayers to automatically take advantage of the installment sale method. The installment method defers taxation on a portion of the gross profit based on the ratio of cash received at closing relative to the total cash to be received in the transaction. However, the installment sale method does not lock in a tax rate since the capital gain is taxed at the rate in effect each year when recognized.
If a sale takes place before the changes proposed by the Biden administration are enacted, owners may wish to elect out of the installment sale method to lock into a lower tax rate in the year of the sale. On the other hand, the installment sale method still spreads the burden over multiple years, which may be a better outcome from a present value perspective. A savings of 19.6% (39.6% versus 20% before the net investment income tax) on a multi-million-dollar sale of a business is substantial. If an owner is considering a sale, now might be a good time.
Finally, ESOP-owned companies should take a thorough look at their plan in 2022. Companies often have a target benefit level they are looking to provide to their employees, typically as a percent of compensation. With the possible reduction in value of the company, account balances of the participants will also decline since they are tied directly to the company’s stock price. One solution could be to make a larger contribution in the year of change to reduce the impact on account values with the added benefit of increasing the tax benefit for the company.