Over the past several weeks, President Biden has unveiled several tax proposals that would increase taxes for both corporations and individuals. His plan would increase the corporate tax rate from 21 percent to 28 percent, while the capital gains tax rate for individuals would increase from 20 percent to 39.6 percent for households with income above $1 million. Current tax law allows for a step-up in basis to fair value at the date of death on assets passing through a decedent’s estate to its beneficiaries. Thus, the appreciation in these assets currently escapes taxation at the date of death. President Biden is proposing the removal of this step-up in basis provision which would effectively tax appreciated assets at the date of death.
We have reviewed the proposed tax changes in order to determine their effects on ESOPs. Here are some of our observations:
Section 1042 – will it be more or less advantageous?
An increased capital gains tax rate would make the gain deferral allowed under Section 1042 much more valuable and attractive to a selling shareholder.
However, President Biden would eliminate the step-up in basis provisions when qualified replacement property passes through the seller’s estate. Therefore, the gain deferral currently available under Section 1042 may no longer be permanent and would be triggered upon the selling shareholders death.
Capital gain on the sale of S Corporation stock becomes more expensive.
An increase in capital gains tax rates would cause the sale of S Corporation stock to an ESOP to become much more costly. The effective tax rate in some states could be in excess of 50 percent.
Sometimes when an ESOP is established the selling shareholder may not sell their entire interest to the ESOP. Instead, the sellers may elect to sell their shares in tranches. If an S Corporation shareholder was considering selling an additional tranche of their stock, they may decide to hold off as a result of the proposed increased capital gains tax.
There may be an impact on employer stock valuations.
An increase in corporate tax rates would mean that we may see lower annual valuations of the employer stock. Lower valuations may also impact a company’s repurchase obligations.
For nearly 50 years, ESOPs have enjoyed bipartisan support to encourage employee ownership of private companies. An ESOP offers unique tax advantages to business owners thinking about an exit strategy for their privately-held company. If you are considering selling your business, you should carefully analyze an ESOP for its tax and non-tax advantages and in light of proposed tax reform.
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