2021: An ESOP Trifecta
Tax Policy, Market Timing, Readiness to Sell
By Patrice Radogna, ASA, CPA, ABAR, Partner, Co-Leader, National ESOP Practice
There is an interesting phenomenon that many ESOP specialists, including the ESOP Group at Marcum, are seeing thus far in 2021. There is a marked increase in the number of inquiries by selling shareholders to sell their company to an ESOP, as opposed to a more traditional exit (private equity, strategic buyer, etc.)
We believe the trifecta conditions in 2021 creating such interest include the following:
- 2021 U.S. Tax Policy Outlook
- Market conditions
- Readiness to Sell
2021 U.S. Tax Policy Outlook
With the global pandemic continuing to be a daunting issue for the U.S. economy as of the beginning of the second quarter 2021, President Biden is moving ahead on a dual-track basis to address the pandemic and advance his broader policy agenda. Given the slim Democratic majority in Congress, any tax legislation will likely have two paths to becoming law. It will either need to have near-unanimous Democratic support in the House and bipartisan support in the Senate (under regular order) or be passed through the budget reconciliation process.1 Overall, prospects for action on President Biden’s proposals are strong, due to the Democratic 51-50 Senate majority, which will allow Democrats to use the budget reconciliation process in seeking to advance some of those tax proposals with only Democratic votes.
Biden’s overarching goal is to raise over $3 trillion2 in tax revenue over the next decade. More specifically, on March 31, 2021, President Biden revealed a major infrastructure spending plan (the “American Jobs Plan”) to spend $2 trillion on infrastructure and jobs. In order to pay for the American Jobs Plan, Biden is proposing a tax overhaul (with significant increases in corporate tax for domestic and multi-national businesses), dubbed, the Made in America Tax Plan.3 The key changes to current tax policy in Biden’s overall tax plan (including, but not limited to the elements of the Made in America Tax Plan) are as follows4:
President Biden’s Tax Plan – Major business tax changes5
- Increase the corporate income tax rate from 21% to 28% (which is now part of the recently released Made In America Tax Plan, addressed above);
- Create a corporate minimum tax on book income for corporations with profits of $100 million or more;
- Increase the tax rate on global intangible low-tax income (GILTI) from 10.5% to 21%; and
- Offer tax credits to small business for adopting workplace retirement savings plans.
President Biden’s Tax Plan – Major individual and payroll tax changes6,7
- Restore the pre-TCJA (Tax Cuts and Jobs Act) top individual income tax rate of 39.6% for those with income over $400,000;
- Increase the tax rate on long-term capital gains and qualified dividends from 20.0% to 39.6% for individuals earning over $1 million;
- Eliminate the step-up in basis for unrealized capital gains at death (beyond an exemption amount of $1,000,000 in capital gains) for heirs;8
- Phase out the qualified business income deduction under IRC Section 199A for filers with taxable income over $400,000; and
- Impose a new 12.4% Social Security tax on wages above $400,000 shared equally between the employee and employer.
How does President Biden’s tax proposal impact ESOPs as an alternative to traditional M&A?
- Deferral/elimination of the capital gains tax – this has always been a strong influencer for a selling shareholder to sell their Company to an ESOP. As a C Corporation, a selling shareholder can elect to defer or potentially eliminate the capital gains tax in a qualified ESOP transaction. This is accomplished by making a Section1042 election for the sale of their equity to the ESOP in an ESOP transaction. With capital gains tax rates possibly reaching 39.6%, the avoidance (or deferral) of the capital gains tax is a substantial tax benefit and warrants careful consideration by any shareholder looking to monetize and sell all or even a portion of their stake in their company.
Note that the avoidance of the capital gains tax under Section 1042 assumes that the Biden tax plan is not successful in legislating the elimination of the step-up in cost basis at death (for property transferred to heirs), as the step-up in basis is the key in eliminating the capital gains. See footnote 8 for recent proposed legislation on the STEP Act.10
- Minimization or avoidance of corporate income taxes – if a Company remains a C Corporation, there are significant deductions available to the corporation for mitigating taxes as an ESOP. If the Company is organized or elects S Corporation status, the Company can minimize taxes, or in many cases, altogether eliminate corporate income taxes.11 With a proposal to increase the corporate income tax rate from 21% to 28% (thus reversing the increased economic wealth experienced by business owners since the income tax rate was lowered to 21% in the prior administration), many business owners are looking to be proactive at finding ways to minimize/eliminate taxes.
The above potential tax changes are significant factors in determining whether to sell to an ESOP. The potential changes in tax policies (including increased individual capital gains tax rates as well as increased corporate income taxes) increase the value of an ESOP to a selling shareholder. A recent New York Times article quoted a wealth advisor who stated “ESOPs may become more popular next year  if the Democrats hit the trifecta and raise the capital gain rates to 39%.”12
Market ConditionsThe pandemic-induced recession was particularly harsh in 2020, but surprisingly short – a recession that many top economists have stated was the shortest recession in U.S. history. The pandemic caused a halt in M&A activity beginning in March 2020, as uncertainty in the economy loomed for both sellers and lenders. In spite of the continuing uncertainty caused by the pandemic, the economy regained momentum and companies were forced to find innovative ways of operating (starting in late summer 2020). While important trends started to emerge. Capital markets were eager to lend to qualified candidates. And, importantly, privately held business owners, who had halted consideration of selling in early 2020 began expressing an interest in ESOPs as a potential buyer. ESOPs provide both a tax-advantaged exit to selling shareholders and have shown greater resilience13 to market disruption due to their tax-advantage structure and inherent alignment of interests between employees, the company and ESOP sellers.
Emotional Readiness to Sell
After a roller coaster year, due to the COVID-19 pandemic, the adjustment of operations and the beginning recovery by companies and the U.S. economy, we are having interesting conversations with business owners. A few items that have surfaced as motivators in the consideration to sell (and particularly to consider an ESOP) are:
- Succession planning, a planning area that is often tabled, has risen in the list of priorities by business owners. The realization that an exit on “their terms” versus an event triggering a forced exit is optimal and requires focused consideration; and
- Reflecting on the business roller coaster and life experience of the pandemic, many owners are finally seeing the light at the end of the tunnel. Business owners experienced significant stress and teetering emotions throughout the pandemic. As market conditions are much more optimistic, business owners have a renewed optimism that they could actually now exit at a strong multiple (see below regarding current multiples).
What do the statistics show regarding current M&A activity in 2021? The statistics show that the total number of M&A deals are fairly stable as compared to last year, but that valuation multiples are markedly stronger in 2021 than in 2020. While it is premature to know how many companies are choosing ESOPs versus other alternatives, the looming tax change coupled with strong valuation multiples are creating a compelling case for business owners to consider selling to an ESOP. The anecdotal evidence experienced by the ESOP Group at Marcum is showing that business owners are prioritizing the following items in considering the sale of their company:
- The potential negative impact of increased taxes, based on the proposed Biden Tax Plan, including both the potential rise in the individual capital gains tax rate and in corporate income taxes;
- The positive impact of rewarding long-time employees by providing continued employment and an enhanced retirement benefit, post-sale of their company; and
- The desire for selling shareholders to sell the often times largest, yet most illiquid, asset in their portfolio (their stake in their company). By using an ESOP owners have flexibility in determining the exit that best fits their needs and their timing.
The combination of the above factors favoring ESOP M&A, including the greater desire to understand the benefits of selling to an ESOP and the very relevant tax and market conditions as well as readiness to sell for certain business owners are key factors in today’s heightened interest in ESOPs.
The ESOP Group at Marcum has been answering a host of questions on a regular basis for our own Marcum assurance and tax clients. Although this is anecdotal evidence that ESOPs are garnering significant attention, the signs are too compelling to miss that ESOPs will be strong contenders as buyers for selling shareholders in 2021. We believe 2021 and future years will all be years of the ESOP Trifecta, based on factors that are here to stay.
- Reconciliation is, essentially, a way for Congress to enact legislation on taxes, spending, and the debt limit with only a majority (51 votes, or 50 if the vice president breaks a tie) in the Senate, avoiding the threat of a filibuster, which requires 60 votes to overcome. Because Democrats have 50 seats in the Senate—plus a Democratic vice president—reconciliation is a way to get a tax-and-spending bill to the President’s desk even if all 50 Republicans oppose it.
- National Law Review, April 2, 2021. https://www.natlawreview.com/article/corporate-tax-hikes-biden-s-infrastructure-plan
- The full scope of the Biden tax plan is beyond the scope of this article.
- The below list is not a complete list of the proposed individual income tax changes under the Biden tax plan.
- Legislation was proposed by several senators on March 31, 2021, proposing legislation on the step-up in basis, referred to as the Sensible Taxation and Equity Promotion (STEP) Act. https://www.insidernj.com/press-release/booker-van-hollen-colleagues-announce-new-legislation-close-stepped-basis-tax-loophole/
- Under IRC Section 1042, eligible shareholders can defer capital gains tax on eligible stock sold to an ESOP if the proceeds of the sale are reinvested in qualified replacement property (“QRP”). Taxes will be deferred until the taxpayer disposes of the QRP. If structured properly, and if QRP is held until death, under current legislation (assuming a step-up in cost basis at death) the taxpayer can avoid paying all capital gains taxes. Section 1042 is similar to the real estate provision IRC 1031 and life insurance IRC Section 1035.
- Efforts were made to change this tax rule in 1976, 2001 and 2015, according to the Tax Policy Center. https://www.forbes.com/advisor/investing/stepped-up-basis-biden-tax-plan/
The elimination of all federal (and most state) income taxes is possible for an S Corporation, as the ESOP Trust (the shareholder of the Company) is a tax-exempt entity. Thus, income passes through to the shareholder and there are no taxes for a 100% S Corporation (while there would still be taxes for any other shareholder, if the ESOP is not the 100% shareholder of the Company). https://www.nytimes.com/2020/10/23/your-money/sale-company-employees-esop.html
- A significant new study by the Employee Ownership Foundation has shown that majority employee-owned companies with Employee Stock Ownership Plans (ESOPs) outperformed non-employee owned companies during the COVID-19 pandemic in the areas of job retention, pay, benefits, and workplace health safety. https://employeeownershipfoundation.org/sites/eof-master/files/2020-10/EOF_CovidResearch_Oct23b.pdf