Some of these laws were amendments to ERISA, but most were either amending the Internal Revenue Code or dealt with specific agencies. This article only provides brief descriptions of what are often complex laws.
The first mention of ESOPs in federal law was the 1973 Regional Railroad Reorganization Act, which created Conrail to subsume a number of railroads into a single company. Under this legislation, Conrail was required to set up an ESOP that would own 15% of Conrail stock, with the government owning the rest. The government later disposed of its stock and Conrail went public in 1987.
ERISA was a major legislative overhaul of retirement, health, and other employee benefit plans designed to deal with various abusive practices, especially in pension plans. ERISA essentially codified the existing ESOP model by making it part of retirement plan law and subject to most of the same requirements for eligibility, vesting, and allocation. ESOPs were allowed a longer distribution schedule than other defined contribution plans, however. Critically, ERISA stated that ESOPs were exempt from the normal prohibited transaction rules that prevented retirement plans from purchasing shares from a party in interest (an existing owner) and from borrowing money. ERISA also exempted ESOPs from normal diversification rules by requiring that they be invested primarily in company stock. ERISA did not add any new tax benefits, which at the time were primarily limited to the deductibility of contributions to the plan up to a limit of 15% of eligible pay, but it did make it clear that this was the law and not something to be applied case-by-case. ERISA also established that the trustee of the ESOP was the legal owner.
This law created the Tax Reduction Act ESOP (TRASOP) by providing an additional 1% tax credit for qualifying capital investments if the company contributed an equivalent amount of stock to an ESOP.
The Revenue Act of 1978 created Section 409(A) of ERISA, which spelled out for the first time the requirement that shares in a private company be subject to a fair market valuation. It codified regulations for TRASOPs, and specified that distributions could be made in cash or in stock, but the employee must have a put option for stock distributions. Employees must be able, however, to demand that distributions be made in the form of shares.
The Technical Corrections Act of 1979 clarified an uncertain area of the law by stating that leveraged ESOPs were subject to the same 409(A) rules as other ESOPs.
The Chrysler Loan Guarantee Act provided emergency credit to rescue Chrysler from bankruptcy. As part of that, it required Chrysler to set up an ESOP with $162.5 million.
The Small Business Employee Stock Ownership Plan Act provided that the SBA be able to make loans directly to the ESOP trust. At the time, loans directly to the ESOP trust were the norm, but the SBA had ruled that such loans were impermissible because the trust was not a small business. The SBA largely ignored the law, however.
The Economic Recovery Act of 1981 eliminated TRASOPs and replaced them with Payroll Based ESOPs (PAYSOPs), providing the employer with a 0.5% credit against payroll for contributions to an ESOP. The law provided that companies with a majority of their stock held by employees could require that distributions be made in cash, a change from existing rules.
The Tax Reform Act of 1984 added the most significant ESOP-specific tax benefits. These included:
The Tax Reform Act of 1986 made a number of changes to ESOPs, most notably:
The Omnibus Budget Reconciliation Act of 1989 limited the 50% interest income exclusion on ESOP loans to ESOPs acquiring at least 50% of the stock in the company. It also repealed the estate tax exclusion for sales to an ESOP.
The Small Business Job Protection Act provided that S corporations could have ESOP trusts as owners, provided the ESOP trust paid unrelated business income tax on its pro-rata share of profits.
This bill repealed the unrelated business tax requirement for ESOP trusts in S corporations, meaning that profits attributable to the ESOP’s ownership would not be subject to income tax.
In response to abuses of the S ESOP corporation tax benefit, this law created a set of anti-abuse requirements (Section 409(p)) for ownership in an S ESOP designed to prevent ownership from being concentrated in the hands of a limited number of people.
The bill also increased the percentage of compensation that could be contributed to ESOPs from 15% to 25% of eligible pay.
The Pension Protection Act of 2006 required that employees be able to move employer stock out of their 401(k) plans and ESOPs. For employer non-elective or matching contributions, the diversification requirements apply after the participant has completed at least three years of service. For elective deferrals and after-tax contributions, the diversification requirements apply immediately. Stand-alone ESOPs without elective employee or matching contributions were excluded from the new diversification rule.
The bill also shortened the maximum vesting period for all defined contribution plans to six years.
The Main Street Employee Ownership Act updated rules for the Small Business Administration to make lending to ESOPs more practical than under existing rules. The SBA issued operating procedures, however, that largely vitiated congressional intent.
The National Defense Authorization Act of 2021 contains the first-ever government contracting program to specifically encourage ESOPs. Under a five-year pilot program, DOD contracting companies that are 100% ESOP-owned qualify for noncompete follow-on contracts for the work.
The bill also directs the Department of Defense to look at “acquisition authorities that could be used to incentivize businesses to become qualified businesses wholly owned through ESOPs and to overcome challenges to partnering with the Department.”
The American Rescue Plan Act of 2021 (P.L. 117-2) included an appropriation of $10 billion for another round of funding for the State Small Business Credit Initiative (SSBCI), a program that has been in place since 2010. The SSBCI program was created to increase access to capital for economic development through small businesses. Funding has not been historically available for business transactions, but in a floor dialogue on the bill, Congress directed the Treasury Department to include transitions to employee ownership in the program. Under the program, states’ programs can (but are not required) to use the money both for direct loan support and technical assistance for employee ownership conversions.
The CHIPS Act of 2022 created regional technology and innovation hubs. Included in a long list of eligible recipients for training grants from the program are organizations that promote employee ownership. The bill also directs Manufacturing Excellence Programs under the National Institute of Standards and Technology to include employee ownership in their list of potential outreach efforts.
The Consolidated Appropriations Act of 2023, an omnibus spending bill enacted in December 2022, had three provisions on ESOPs, all under the part of the bill called the WORK Act.
The bill created a federal program to fund state employee ownership outreach and training programs. Under the law, the Department of Labor would establish an Employee Ownership and Participation Initiative to promote employee ownership and employee participation in business decision-making. The program would be funded at $4 million in fiscal year 2024, gradually increasing to $16 million by fiscal year 2028. The DOL set up the initiative in 2023. Funding for the grant program is dependent upon a yearly appropriation being made by Congress. See page 15 for the latest update on this legislation.
The funds can go to existing state programs or to create new ones. States can contract out the work to qualified organizations or create the program in-house. If a state does not apply, nonprofits can apply in the following year. Funds can be used for training, technical assistance, and working with local organizations to help business owners understand how employee ownership through ESOPs, worker cooperatives, or employee ownership trusts can be used for business succession.
The bill also required that the Department of Labor develop “acceptable standards and procedures to establish good faith fair market value for shares of a business to be acquired by an employee stock ownership plan.” ESOP advocates have long sought this clearer guidance on ESOP valuations, arguing that the lack of standards has led to unwarranted ESOP litigation.
Finally, the bill provides that starting in 2028, sellers to an ESOP in an S corporation can defer 10% of the tax on the gain by reinvesting in stocks and bonds of US operating companies. The tax deferral is based on the 100% tax deferral available for sales to an ESOP in C corporations. It was limited to 10% because of budget concerns.