What ESOPs need to know about tax reform and a recent court ruling

By Peter J. Shuler and Mark D. Swanson, J.D.
What ESOPs need to know about tax reform
H.R. 1, commonly known as the Tax Cuts and Jobs Act of 2017 (TCJA), does not have provisions that specifically address employee stock ownership plans (ESOPs), but it could indirectly affect such retirement plans because of how ESOP valuations are performed and because of limits on the deduction of interest expense.
The TCJA’s most significant provision is the reduction in the highest corporate tax rate to 21 percent. ESOP company valuations often are based on the discounted cash flow method, in which the appraiser usually begins with earnings before interest and taxes (EBIT) and subtracts estimated federal and state income taxes. With the reduction in federal taxes, the result – all things equal – should be an increase in the stock value. 
An appraiser also might use a market approach whereby the value is determined by comparing similar companies using one of two methods. The guideline public company (GPC) method, as the name suggests, compares publically traded companies to the private ESOP company. The market’s response to the reduced tax and resulting higher expected profits is reflected in the pricing multiples of the publicly traded companies. The other market approach, the merged and acquired company method, is based on the appraiser’s use of data on recent merger and acquisition (M&A) transactions that could provide a comparison for the ESOP company value. Because M&A transactions wouldn’t reflect the TCJA’s tax reduction, if the appraiser can find comparable M&A transactions, adjustments would be necessary to reflect the appropriate multiples. 

Long-ranging impact

S-corporation ESOPs usually are valued as if they were taxable C corporations, even though the S-corp does not pay taxes at the corporate level. With the lower federal tax rate, the share value of the S-corp might increase, resulting in a higher repurchase obligation but no increase in cash flows to help meet the obligation. A review of the S-corp ESOPs distribution policies might be in order to help manage any impact of the TCJA and the repurchase obligation. 
The TCJA also could limit the deduction for interest on loans used to acquire shares. Most ESOP transactions that borrow in order to acquire stock are structured with a loan between the ESOP and the company in which it holds shares (the inside loan) and a separate loan between the company and lender (the outside loan). Though there are many details and exceptions to consider, the TCJA generally limits to 30 percent the deduction for net interest expense to adjusted taxable income (ATI). For 2018 through 2021, ATI is taxable income plus earnings before interest, taxes, depreciation, and amortization (EBITDA). Beginning in 2022, depreciation and amortization are excluded from ATI. Any interest expense in excess of the 30 percent limit can be carried forward to future years. These new limits are not a concern for S corporations that are 100 percent ESOP-owned because such entities do not pay federal taxes.  

Court ruling cause for caution

In 2017, the U.S. Tax Court ruled the deduction of accrued compensation expense by an S-corp can be deducted only in the same year it is included in the income of the related party. The case involved the deduction of compensation that was reflected as an accrued expense in one year but actually paid and included in the employee’s taxable income in the following year. 
Under IRC Section 267(a)(2), a taxpayer may deduct an expense only in the same year the payment is reported as taxable by a related party. In the case of an S-corp, a related party includes anyone who directly or indirectly owns S-corp stock. Therefore, if an ESOP holds stock, the ESOP participants are considered to indirectly own the stock. The participants do not include accrued compensation in their income until the income is received, so the S-corp cannot deduct any compensation (including bonus or vacation pay) accrued to these participants. The S-corp also cannot deduct any qualified retirement plan contributions that are based on accrued compensation for these participants. The court’s decision makes it clear S-corps need to exercise caution relating to the deduction of compensation expenses.  

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Pete Shuler
Principal, Benefit Plan Tax Services Leader