Since the Tax Cuts and Jobs Act (TCJA) was signed into law on December 22, 2017, the employee stock ownership plan (ESOP) community has closely watched the tax reform process for any potential effects on ESOP-owned companies. This article highlights some of the significant provisions included in the law that will affect these companies.
S Corporation ESOPs
The good news is the S corp ESOP tax benefit was retained. The portion of S corp earnings attributable to the ESOP is exempt from federal and most state income tax (except in states that don’t recognize S corp status). When an S corp is 100 percent owned by an ESOP, the company is no longer subject to federal or—in general—most state income taxes.
Changes Affecting C Corp ESOPs & Partially ESOP-Owned S Corps
Portions of the TCJA may affect C corps and S corps that are less than 100 percent ESOP-owned. Here are a couple of the major changes:
- Corporate tax rate
- Under previous tax law, C corps were subject to a graduated tax structure with a top tax rate of 35 percent. Under the new tax law, C corps are subject to a flat 21 percent rate, effective January 1, 2018.
- This will typically benefit C corp ESOPs.
- Interest expense
- In general, interest expense was fully deductible under previous tax law. Under the new law, the interest deduction is limited to business interest income, floor plan financing interest and 30 percent of the entity’s adjusted taxable income.1 Any excess interest is indefinitely carried forward.
- This could affect leveraged ESOPs when the company borrowed money to finance the acquisition. This may be especially detrimental if the company borrowed a substantial amount of money in comparison to its adjusted taxable income.
Effect on ESOP Valuations
Another area of interest is the potential effect on ESOP valuations. Many ESOP valuations consider the discounted cash flow (DCF) method, which places a value on the company’s after-tax cash flow. Under the DCF method, the earnings of both S and C corps are tax-affected. As mentioned above, the corporate tax rate was reduced from a top rate of 35 percent to a flat 21 percent rate. This will potentially increase the projected after-tax earnings of many ESOP companies, resulting in higher valuations.
The increase in stock value will lead to higher ESOP repurchase obligations. Because C corp ESOPs generally will see a reduction in their corporate tax rate, they should theoretically have additional cash to fund this increased repurchase obligation liability. However, because 100 percent S corp ESOPs don’t pay corporate income taxes, they may see an increase in their repurchase obligation with no corresponding increase in actual cash flow.
To learn more about ESOPs and the TCJA’s effect, contact Cara or your trusted BKD advisor.
1 Adjusted taxable income is defined as taxable income without regard to items not properly allocable to a trade or business, any business interest expense or business interest income, the 20 percent pass-through income deduction, any net operating loss deduction and, for taxable years beginning before January 1, 2022, any deduction for depreciation, amortization or depletion. The interest limitation doesn’t apply for any taxpayer that meets a $25 million gross receipts test or is a regulated public utility business (including electric cooperatives). Certain real property and farming businesses may irrevocably elect not to be subject to the limitation provided they use the Alternative Depreciation System method to depreciate certain types of property within these businesses.