The Impact of Tax Reform on ESOPs

By Cara Benningfield

The Tax Cuts and Jobs Act (TCJA) was signed into law on December 22, 2017. The employee stock ownership plan (ESOP) community had been closely watching the tax reform process for any potential effects on ESOP-owned companies. This article will highlight some of the significant provisions included in the final law that will affect these companies.

S Corporation ESOPs

The good news is the S corporation ESOP tax benefit was retained. This is a substantial benefit for S corporation construction companies that are ESOP-owned. The portion of the S corporation earnings attributable to the ESOP is exempt from federal and most state income tax (except in states that don’t recognize S corporation status). When an S corporation is 100% owned by an ESOP, the company is no longer subject to federal or, in general, most state income taxes.

Changes Affecting C Corporation ESOPs and Partially ESOP-Owned S Corporations

Portions of the TCJA may affect C corporations and S corporations that are less than 100% ESOP-owned. Here are a couple of the major changes:

  • Corporate tax rate:
    • Under previous tax law, C corporations were subject to a graduated tax structure with a top tax rate of 35%. Under the new tax law, C corporations are subject to a flat rate of 21%, effective January 1, 2018.
    • This will typically benefit C corporation ESOPs.
  • Interest expense:
    • Under previous tax law, interest expense was generally fully deductible. Under the new law, the interest deduction is limited to business interest income, floor plan financing interest, and 30% of the entity’s adjusted taxable income.* Any excess interest is carried forward indefinitely.
    • 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.

Impact on ESOP Valuations

Another area of interest is the potential effect on ESOP valuations. Many ESOP valuations, including valuations of companies in the construction industry, 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 corporations are tax affected. As mentioned above, the corporate tax rate was reduced from a top rate of 35% to a flat 21% 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 corporation ESOPs will generally see a reduction in their corporate tax rate, theoretically they should have additional cash to fund this increased repurchase obligation liability. However, because 100% S corporation ESOPs do not pay corporate income taxes, they may see an increase in their repurchase obligation with no corresponding increase in actual cash flow.

As the leader of BKD’s ESOP practice, Cara L. Benningfield, CPA, structures and facilitates the creation of new ESOPs and works with existing ESOPs in matters ranging from acquisition structuring to repurchase planning and analysis. Her experience with ESOPs also includes providing financing assistance, tax planning, ongoing plan administration, employee communication, and structuring of executive incentive plans. She can be reached at [email protected] or 270-781-0111.

*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% 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 does not 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.