The tax plan to fund President Joe Biden’s $6 trillion proposed budget contains a number of new revenue-raising measures, most imposed on the highest-earning Americans and corporations. One of the tax hikes, a proposed 7% increase to the capital gains tax, could have an unexpected side effect: A major uptick in employee-owned businesses.
Currently, over 10 million Americans work for employee-owned companies, which are any business where a significant portion of ownership is controlled by an employee stock ownership program (ESOP). Employees are typically awarded more shares the longer they work, and are often entitled to profit-sharing. While most ESOPs are in relatively small, privately-held companies, the model has also been adopted by large employers like Publix and the staffing firm Penmac.
Companies transition ownership to employees for a number of reasons, but it typically occurs when a private owner is looking to retire and sell off their stake. If the owner opts to cash out by selling their shares to another private buyer, they’re subject to paying a capital gains tax. But if they sell to an ESOP that’s registered as a C-corporation, they aren’t liable for any capital gains taxes, provided that a couple of additional requirements are met (for example, at least 30% employee ownership). The capital gains tax hikes suggested by Biden would make that kind of sale all the more appealing.
“What really pushes most owners over to ESOP sales is legacy. They’re invested in the company being rooted in the community,” says Loren Rodgers, the executive director at the Oakland, CA-based National Center for Employee Ownership. “But, if we take as a given that Biden’s tax ideas get put into place, it would definitely be a pretty major shift in the incentive to create ESOPs.”
Legacy was the defining factor for third-generation family business Onex, which transitioned to an ESOP in July 2020. Ashleigh and Andrew Walters had purchased the Erie, Pennsylvania, company, which manufactures ceramic linings for industrial furnaces, from his father in 2019. They were invested in the business’ long-term health, but realistic about those prospects if they were to keep it in the family.
“Third-generation family businesses only have a 13% success rate,” says Ashleigh. “We have two sons, and if they want to come work for us they can, but we wanted to be very thoughtful about how we planned for the business.”
Ashleigh was inspired to set up an ESOP after hearing the head of Pennsylvania’s Center for Employee Ownership speak at an event. After talking it through with Andrew, the two worked with PNC Bank to transition into a S-corporation ESOP. The tax benefits were significant: S-corp ESOPs pay no federal or state income taxes, and the company was able to use the tax savings to fund their buyout.
The tax and economic benefits aren’t the only appeal of ESOPs. Retention is top of mind for many employers, and few businesses have retained talent better through the pandemic than employee-owned companies. A poll released earlier this month from John Zogby Strategies found that just 4.5% of people working at S-corporation ESOPs lost their jobs or saw work hours reduced during the pandemic, as opposed to some 30% of the general population. The strategy has worked at Onex. Over the course of the pandemic, the company hired, boosting its staff to 50 employee-owners.
The policy picture isn’t without its complications. Biden’s tax plan also includes a proposal to raise the corporate income tax rate from 21% to 28% (though a deal with Congressional Republicans could entail a significantly smaller hike). That could indirectly affect a business owner’s buyout. When an owner is looking to sell, their company is valued at a fair market price by a third-party auditor. An increase in taxes is likely to bear out a more conservative valuation. While painful, that hit may not be enough to discourage sellers.
“If we’re talking about a 4%, 7% or 8% increase from a corporate tax standpoint, it’ll likely have less of an impact than the potential impact to capital gains,” says Caroline Donlan, managing director and group head for corporate advisory at BMO Harris. “You’ve got to run the numbers, but in broad strokes, it’s probably still attractive [to sell to an ESOP].”
ESOPs that are organized as S-corporations have a slightly less volatile orientation. They aren’t subject to the same capital gains exemption as sales to ESOP C-corps, and they’re not affected by the corporate income tax. If Biden’s proposed tax hike for those in the top income bracket passes, raising the rate from 37% to 39.1%, you could see a slight decline in new S-corporation ESOPs.
“Conversely, when taxes were cut under Trump, a lot of ESOPs saw their valuations change for the better,” says Donlan.
Other policies are more ambiguous. Biden’s “Buy American” mandate for federal contracts could stand to benefit employee-owned companies, all of which are legally based in the U.S., by providing a lucrative fast-track to well over $600 billion in federal work orders a year.
An increase in employee-owned firms might also have the potential to break the employment logjam that’s facing many sectors due to low wages. A 2017 study from the NCEO found that median wages for ESOP employees aged 18-24 were 33% higher than the national median.
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June 28, 2021 at 08:24PM
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