Celebrate with us as we mark 25 years of tax-free employee-owned companies! In our latest podcast, Kevin Long explains the tax incentives for S corporation ESOPs that make this possible and with his special guest takes us on a journey through the history of income tax-free employee-owned companies and how ESOPs allow for tax-free S corporation income.
Transcript
Kevin:
Speaking of Benefits, this is Kevin Long. In 2023, we’re celebrating 25 years of income tax-free employee-owned companies. That’s a little bit of a sensationalist headline, but what we’re talking about is employee stock ownership plans where if employees own part or all of a subchapter S corporation in an ESOP, then part or all of that S corporation income is not going to be taxed. It can be any percentage, including up to 100% and that’s how you get to tax-free S corporation ESOPs. Tax-free. Think about it. An S corporation issues K1s to its shareholders. If the ESOP is one of those shareholders, then that K1 goes into the desk drawer because to paraphrase the Humphrey Bogart movie, “We don’t pay no stinking taxes if we’re an ESOP S corporation.”
So what happens to all that money? There’s money that’s distributed by the S corporation to the shareholders normally to allow the shareholders to pay their taxes. If there’s a partial S corporation ESOP, the non-ESOP shareholders get their money and the ESOP gets its share. What happens to that? It doesn’t go to Uncle Sam in taxes. The ESOP can actually use that money to help pay for the stock that it’s buying and they can also use the money in the ESOP to pay the benefits to employees that leave the company. If you do the math, you have 35% to 40%, which is a normal tax rate in any given state, so 35% to 40% of the cash is being distributed out of the ESOP every year. Or if you’re 100% ESOP-owned, you can keep that money in the corporation and you wind up with a corporation with a 35% to 40% capital advantage. What for-profit company would like to have another 35% to 40% of income and cashflow for their operations?
This has been going on for 25 years and I don’t understand sometimes why more CPAs, lawyers, and financial advisors don’t know about this and why they’re not telling their clients about it. But actually I do know, it’s really obscure and it’s tucked into our corner of the code that most of these advisors delve into. It’s in the retirement plan sections of the code, which is why it’s taken some pretty dramatic lobbying and legislative events to make this come to pass. This brings us to why we have our special guest today, Noelle Montaño from ESCA, The Employee-Owned S Corporations of America, a trade association and lobbying group in Washington D.C. For the last 20 years, Noelle has been in the thick of it in the heart of our legislative machine in Washington. She is doing a very effective job of fighting the good fight and promoting employee ownership. Noelle, thank you for joining me this morning.
Noelle:
Kevin, thank you for having me. When I hear you discuss the benefits of S corporation ESOPs, even though I’ve been doing this for 20 years, I still get excited and amazed that Congress created this structure.
Kevin:
If you really want to see very simply how significant this is, use the ESOP calculator on the home page of our website. You can enter 10 inputs and it will run a comparison of a regular C corporation tax-deferred goal over transaction and an S corporation ESOP. You can print out a breakdown of what those line items are. It shows you that while a 1042(c) corporation ESOP gets a 30% tax subsidy due to the deductibility of funding through the plan, an S corporation ESOP transaction can be 66% funded. It has a 66% tax subsidy from Uncle Sam to pay for those shares.
It’s really mind-blowing. If you’re the least bit curious about whether or not I’m telling the truth, I encourage you to go to the ESOP calculator and plug in some numbers. I think it’s kind of fun, but then I’m an ESOP nerd. Given that it is such an incredible tax advantage device, a lot of times we get questions from advisors, “Is that a loophole? Does that really work? Is the IRS and Congress going to get rid of it once they figure out what’s really going on?” The fact of the matter is employee ownership is public policy in this country. Employee ownership and in particular ESOPs have been supported by both sides of the aisle forever. ESOPs have been around since the 1950s. In the early 1980s, Ronald Reagan, a Republican from California, was a staunch advocate of ESOPs because California is the birthplace of ESOPs.
Ronald Reagan brought them to Washington and as President in 1980 and 1984, he put provisions in the code to give us this tax-deferred rollover and deductibility of these transactions. Since 1984, things have taken off and there’s only been one tax bill since that time that has negatively impacted ESOPs. Ironically, it was the Democratic Clinton administration in 1993. As part of the wheeling and dealing in Congress, the S corporation lobby had to give up a tax benefit because that’s what you do in Washington. Things are driven by revenue and you have to make concessions. We gave up a benefit that no one was really using, so ESOPs saw a legislative take back, but it didn’t bother ESOPs quite frankly at all.
Then we roll forward to 1998 and we have this huge shift in the ESOP landscape and to our amazement, we’re here 25 years later, which gets us back to our guest, Noelle, and your organization, ESCA. I think there’s a couple of things that people need to learn from you. First of all, I want you to give them your background, which explains why you’re so good at what you do and why you’re the right person for ESCA. Then we want to talk about the background of ESCA and the proactive and the defensive work you’re doing and how that all gets done.
Noelle:
Thank you, Kevin. I started out right after college wanting to work for my hometown member of Congress. I was not politically active, but I was a public policy major. I moved back home to Houston and I thought, “I wonder who my member of Congress is.” Well, a lot of luck goes into this and timing is everything. My hometown member of Congress was Congressman Bill Archer, a Republican from Houston. In the early 1990s, he was the lead Republican on the House Ways and Means Committee. The House Ways and Means Committee is the only congressional committee that is mentioned in the Constitution. All tax bills must originate in the House and thus they originate in the House Ways and Means Committee. It was my great fortune to get a job with Congressman Bill Archer.
In the 1994 election, the Republicans took the majority in the house after 40 years of Democrat control of the House. The Republicans won control and Congressman Archer became the Chairman of the House Ways and Means Committee. I was working for him when the law was changed in 1996.
Kevin:
The House Ways and Means Committee is arguably the most powerful seat in Congress. It’s the gatekeeper for money and taxes and that drives everything in our society.
Noelle:
Social Security, trade, healthcare, tax policy, and welfare policy goes through the House Ways and Means Committee. 1996 was the year of the Small Business Job Protection Act and that is where the legislation was created to allow an S corporation to be owned by an ESOP. As you mentioned, definitely not a loophole. It was clear congressional intent to create this structure to promote retirement savings and employee ownership. I was on the Hill when that was done as a more junior staffer. I was not aware in 1996 that in 2023 I would have worked on behalf of S corporation ESOPs for more than 20 years.
Kevin:
That’s where you started and learned and now you’re wielding some influence yourself in Washington. We’ve talked before and there’s a little vignette about how this really came to pass. The genesis of this whole thing and getting it done. It’s really interesting.
Noelle:
It all started when our CEO, Stephanie Silverman, was representing a client who owned an S corporation business. He was looking to retire and transition out of the business. His children were not interested in the business as happens with future generations oftentimes when there’s a family business. They didn’t want to run it. They had other interests. The business owner asked Stephanie, “Well, this seems kind of unfair. Why can I not transition my S corporation to ESOP ownership? C corporations can be owned by ESOPs.” She was representing the S Corporation Association at this time and along with a handful of company members, they engaged with House Ways and Means Committee members and Senate Finance Committee members to advocate for a change in the law that ultimately created this new structure. It was very complicated and took a lot of work and explanations to members of Congress about why you are marrying a pass through entity with a qualified retirement savings plan and how that works to provide for retirement savings for the new employee owners of these companies.
Kevin:
Interestingly, it’s the closely held businesses that represents 60% of our economy that we’re able to move something that is incredibly obscure as rooted partly in the pension laws, which nobody understands.
Noelle:
ERISA, right?
Kevin:
Right, which is why we have a job.
Noelle:
ERISA and the tax code, it’s a lot of fun.
Kevin:
How do you make sense of the tax code? Business owners who are paying the taxes and making the economy go, they go to Washington and just like they did in 1984 when they created the tax deferred rollover, they march to Washington and say, “Hey, my company’s going to disappear if I don’t sell it to my employees. How are you going to make this happen?”
Noelle:
Exactly. ESCA exists to ensure that the S ESOP benefit continues, because I think you’ve mentioned what Congress giveth, Congress can take away. There is no guarantee when you are a creature of statute that you will be there forever. We cannot pass a law that says S corporation ESOPs are working even better than anyone ever intended. Congress will never touch them. That cannot be done, so we need an ongoing coalition, which is what ESCA is. We now have 200 member companies ranging in size from 50 employee owners to 40,000 employee owners in a variety of industries, including construction, engineering, contracting, old line manufacturing, and retail grocery stores. They all have a common theme and the common structure of how they are looking out for their employee owners by being a private and employee-owned company.
Kevin:
It doesn’t matter what industry you’re in or how small your S corporation ESOP is, you need to support ESCA. You need to join because you have great tax benefits and if you don’t, you have a risk of losing them. Pay for your membership with some of the tax dollars you’re not sending to Washington. It’s not a lot of money to join ESCA, but it is a lot of risk not to and ESCA is doing great work.
Noelle:
We aim to be the insurance policy. We know that our members are involved with ESCA, so that while they are busy running and growing their businesses, and these businesses do grow because of the structure and capital that’s involved, ESCA is their eyes, ears, and voice in Washington D.C. ESCA ensures there is policy support for this, and members can tell their current group of employee owners that they are in it for the long haul and looking out for future generations of employee owners through their membership in ESCA.
Kevin:
You talk about growth. I’ve seen it in the 35 years that I’ve been working in the ESOP field. It’s mind-blowing how rapidly a corporation can grow with this tax protection or tax shield as we call it. We have clients that started with 50 employees and $20 million in revenue and now they are $300 million in revenue and acquiring companies like Packman. If you’re old enough to remember Packman. They are becoming M&A entities of themselves.
Noelle:
That’s really exciting for us because when an S ESOP company acquires another company, those new employees become employee owners. We had one of our board members tell us once that they acquired a family-owned business and those new employee owners told them something like, “I used to work for a family business and I never felt like family. Now that I’m part of an ESOP, I feel like family.” That gives me the chills still talking about it. But again, those are the stories we hear and those are the stories we convey and have our members talk to members of Congress about to build the support for employee ownership.
Kevin:
In that family, they’re getting great benefits. You have some good information about the magnitude of the benefits for the employees in these companies and performance.
Noelle:
It’s looking at this scale of everything, including how much S ESOP companies distribute over the years. This is something we studied a couple of years ago and the figure is $77 billion were distributed to employee owners over a period from 2002 to 2019. Again, billions of dollars that were distributed and I think we always want to focus on the fact that this is retirement savings that is employer provided. 90% of our member companies also offer a 401(k). 50% of working Americans do not have an employer provided plan. They go to work every day, but they do not have a retirement plan provided by their employer. If you work for an ESOP company, you definitely have one. You may have two because our companies care so much about what they are providing in terms of benefits for their employee owners. Another statistic is that ESOP balances tend to be at least two times as big as the 401(k) balances.
Kevin:
It’s nice to have Uncle Sam funding those accounts. I think sometimes when they’re first hearing these statistics, business owners think, “Wow, that’s way too much. Why would we pay them this much?” You’re going to do it for these reasons. Number one, Uncle Sam is helping you fund it. Number two, the ROI, return on an investment, of putting money into an ESOP employee’s account is huge.
Noelle:
We want to make the point that, again, this is designed for broad-based employee ownership, intentionally designed by Congress for that. These plans are designed to help every employee, whether they’re an administrative assistant, receptionist, factory worker, or construction worker. We have working class Americans saving for retirement in a way that they never could have dreamed of and that is such a powerful story along with this data that we have to present to members of Congress.
Kevin:
You mean we’re benefiting frontline employees to use the current term.
Noelle:
Right, the essential workers. Many of our member companies, their employee owners went to work every day throughout the pandemic because they were out there building the infrastructure their country depends on. They were building the plastic containers that COVID tests went into. You’re right, frontline workers that are benefiting from something Congress designed, which is part of the message that Congress did something right. How often do they hear that? This enthusiasm that you did something right and the data and the stories are even better than you ever could have anticipated.
Kevin:
Let’s talk about where ESCA is going and what you’ve most recently accomplished. After years of work, you’ve moved the dial in the legislative era. You were telling me recently about the different climate in Washington.
Noelle:
Going back to the beginning days of ESCA, we knew we had to play defense, so we met with members of Congress and their staff. We gave them data and introduced them to employee owners in their districts and states that talked about how much employee ownership means to them. Eventually, we had members that served on the House Ways and Means Committee or Senate Finance Committee say, “If this is so great, why don’t we have legislation to encourage more private employee ownership?” We’ve worked for years on legislation that the primary provision is 1042 treatment for S corporation owners and this is a benefit that Section 1042 allows C corporation owners to sell to an ESOP and defer paying taxes on the proceeds from the sale as long as they roll over that money into other investments.
We think that 1042 for S corporation owners would create parity with what C corporation owners already get and also provide a very meaningful tax incentive for S corporation owners to first consider and then go through with selling their company to an ESOP. The legislation that we have had for a number of years, we were able to get a partial 1042 benefits signed into law at the end of last year. It’s partial, but ESCA sees this as a very important symbolic victory for the ESOP community because, as you mentioned, there are a lot of professional advisors that may not bring up ESOP ownership to their clients looking to sell. They’ll think about it more now and it also shows the great deal of bipartisan support from tax policymakers.
Kevin:
You’re selling yourself short on this, Noelle. I don’t look at this as symbolic at all. It has a delayed effective date, but I look at it as a foot in the door.
Noelle:
It is.
Kevin:
I got a feeling you’re going to kick that door in before this provision takes effect. I’m betting on you. I can imagine that I’m going to have to change a lot of my documents and software because you’re going to change the law and we’re going to have more ESOP companies and that’s going to be great.
Noelle:
We hope you’re right. We’re looking forward to our Senate lead sponsors introducing the legislation potentially next week, probably by the end of the month for sure, and it will include full 1042 treatment. Our friends in Congress are pushing for it. We’re pushing for it and we will continue to message that as part of our ongoing efforts to play both defense and offense. There’s a lot of inadvertent consequences that can impact S corporation ESOPs, whether it’s entity level taxes, restrictions on the amount that one can accumulate in a retirement savings account, or tax simplification. There have been various threats that we’ve fought back against over the years and our number one mission is to ensure there is no harm done to the current structure while also doing what we can to encourage more S corporation ESOPs.
Kevin:
One of the most interesting, if not amazing things you just said, is that legislators came to you and said, “We’re in favor of employee ownership and why can’t we have more?” They actually wanted to get something done. What’s up with that, as my daughter would say.
Noelle:
S corporation ESOPs make people happy. When you talk to a member of Congress and you tell them you did something right. For all of our listeners who follow the news and what’s going on in Washington, you primarily hear only about all of the fighting and that nobody can agree on anything, so nothing is getting done in Washington. It’s very exciting for the S ESOP community and gratifying that we view ourselves as a bridge. You have members of Congress that are conservative Republicans and liberal Democrats and they want to work together to benefit employee owners by providing for more employee ownership.
We’re a bright spot in the policy landscape and that’s to our advantage. It’s to our benefit and it’s ultimately about benefiting American workers. We like to call the S corporation ESOP the American Dream at work and it truly is. We have Congress to thank for it. We have our friends in Congress to thank for it. While there may be regular turnover through losing elections and retirements, we’re continuing to rebuild our allies and champions in Congress. There is strong support for and encouragement that within these very difficult political times where there’s little that the parties can agree upon, they agree upon employee ownership and ESOPs.
Kevin:
That’s a great high point to finish on in this discussion because we know there are more cynics than optimists when you talk to people about what’s going on in Washington. What you’ve explained to us about ESOPs is a point of optimism in terms of what we can see coming out of Washington and I’m ecstatic for my clients. I’m hopeful that we’ll see more of them and we’re cheering you on, Noelle. We’re going to make sure we get as many of our S corporation clients to join ESCA as we can. We applaud and support your efforts.
Noelle:
Thank you, Kevin. Our website is esca.us. Our big federal policy conference and lobby days in Washington D.C. are September 21-22, 2023. Please check out our website and reach out to us if you’d like to join us for that.
Kevin:
I appreciate you making yet another web podcast a raging success.
Noelle:
Thank you for all that you do, Kevin, for the ESOP community.
Kevin:
If you need specific guidance on this topic, let’s start a conversation. This podcast is for general informational purposes only. It does not create an attorney-client relationship between Employee Benefits Law Group and the listener or reader and does not constitute legal advice for a specific situation.
