"THE EXPANDED EMPLOYEE STOCK OWNERSHIP ACT OF 1978-A SUMMARY AND ANALYSIS"

(By John E. Curtis, Jr., Counsel, Senate Finance Committee and Ronald L. Ludwig, Attorney at Law, San Francisco, and Counsel to Employee Stock Ownership Council of America)

I. TRASOP LEGISLATION

A. Commentary

On June 23, 1978, Senator Russell B. Long, Chairman of the Senate Committee on Finance, introduced the "Expanded Employee Stock Ownership Act of 1978" (S. 3241). This bill marks the latest major congressional effort towards broadening the access of employees to stock and capital ownership in their employers. In the Regional Rail Reorganization Act of 1973,1 Congress provided that the Consolidated Rail Corporation (CONRAIL) could use an employee stock ownership plan (ESOP) as part of its financing program, thereby enabling CONRAIL employees to share in ownership of the new railroad system. In the Employee Retirement Income Security Act of 1974,2 Congress for the first time formally recognized ESOP as an employee benefit plan and established criteria for its adoption and operations. In the Trade Act of 1974, as part of the relief package being established for companies which are members of foreign trade impacted industries, Congress provided that some preference would be given for assistance to such companies which use an ESOP in conjunction with federal loan guarantees. In the Tax Reduction Act of 1975, Congress established the "TRASOP," an ESOP funded through an additional investment tax credit allowed for corporate employees. The Tax Reform Act of 19765 expanded the provisions for TRASOPs and provided guidance to the federal agencies for developing final ESOP regulations.

The purposes of the Expanded Employee Stock Ownership Act of 1978 are to further the steps already taken by prior ESOP legislation and to make the ESOP a better instrument for providing stock ownership to employees. The bill accomplishes these goals primarily by expanding the use of the TRASOP, the special form of ESOP presently tied to the additional investment tax credit available under the Tax Reduction Act of 1975, as amended by the Tax Reform Act of 1976. For purposes of this article, the term "TRASOP" will be used to refer to a "tax credit ESOP," while the term "ESOP" will apply to any ESOP (including a TRASOP). The purpose of this analysis is to explain each provision contained in the bill and to analyze the background problem or underlying reason for its inclusion.

Changes for TRASOP

The major changes made by S. 3241 are in the TRASOP area. As part of the overall increase in the investment tax credit from 7 percent to 10 percent, the Tax Reduction Act of 1975 provided for an additional 1 percent investment tax credit. This credit could be claimed by an employer that adopted a TRASOP (satisfying the requirements established by that Act) and contributed to the TRASOP an amount of employer stock (or cash to buy stock) equal in value to the amount of the additional tax credit claimed. The Tax Reform Act of 1976 expanded this concept, providing that an employer could claim an additional 12 percent investment tax credit for TRASOP contributions (thereby increasing its total available investment tax credit to 111⁄2 percent provided that participating employees made matching contributions to the TRASOP equal to the additional 2 percent investment tax credit). Such employee contributions were a mandatory prerequisite for the claiming of the additional 2 percent investment tax credit by the employer. It is important to note that the additional investment tax credit for TRASOP contributions would largely be available only to capitalintensive corporations, and would have little applicability to labor-intensive corporations. In addition, the Tax Reform Act of 1976 extended the additional investment tax credit for TRASOP contributions only through 1980. This was because the TRASOP was tied to the investment tax credit increase from 7 percent to 10 percent which is due to expire on December 31, 1980.

1 Pub. L. 93-236.

2 Pub. L. 93-406.

3 Pub. L. 93-618.

4 Pub. L. 94-12.
5 Pub. L. 94-455.

S. 3241 makes significant changes in TRASOPS. In the first place, it increases the investment tax credit which an employer can claim for its TRASOP contribution from one percent to two percent. In addition, it removes the provisions for matching employee contributions to the TRASOP; rather, any employee contributions are to be purely voluntary and subject to a decision by the employer at the time that the TRASOP is adopted or amended. More significantly, the TRASOP provisions are to be permanently incorporated within the Internal Revenue Code in new §§44C and 416. This means that TRASOPS would not expire with the tax cuts under the Tax Reduction Act of 1975. Finally, in an effort to broaden this type of ESOP, the bill provides an alternative tax credit based on payroll for labor-intensive companies which adopt a TRASOP and contribute stock to it. This provides a tax credit equal to 1 percent of the compensation of all participating employees under the TRASOP, provided that the employer contributes to the TRASOP an amount of stock (or cash used to purchase stock) equal in value to the tax credit claimed.

In introducing S. 3241, Senator Long noted that this country faces a serious shortage of capital formation. The Chase Manhattan Bank has predicted that over the next decade our economy will require 1.5 trillion dollars of new capital formation. S. 3241 attempts to partially resolve that capital shortage by requiring that the employers who adopt and fund a TRASOP will be doing so in a manner that will generate additional capital formation. The bill requires that at least onehalf of the tax credit claimed for TRASOP contributions (whether based on the additional investment tax credit or the payroll credit) would have to be represented by the transfer of newly-issued securities to the TRASOP.

A major problem which exists in the TRASOP area is the requirement that each employee who participated in the TRASOP at any time during the year must share in the allocation of stock representing the employer's annual TRASOP contribution, even if he was no longer employed at the end of the year. This creates a great recordkeeping problem in that a record had to be maintained as to the location of each terminated participant so that he can receive an allocation (and in most cases a distribution) of stock for the year in which he ceased to be employed by the employer and ceased to be a TRASOP participant. The bill provides that an employer need allocate stock from its current TRASOP contribution only to participants who are employed on the last day of the TRASOP plan year. This is an optional provision and does not preclude an employer, if it so chooses, from making allocations of employer securities to the TRASOP account of a participant who terminated employment during the year.

The Tax Reduction Act of 1975, in establishing the TRASOP, required that each participant must be entitled to direct voting rights on all stock allocated to him under the TRASOP. Generally, TRASOPS have ben established only by large capital-intensive corporations, most of which are publicly-traded. For these companies, the expense and burden of providing participants with the proxy solicitation materials regarding the voting of such shares is relatively minor. However, the requirement for the pass-through of voting rights has acted as a deterrent for closely-held corporations which desired to adopt a TRASOP. With the creation of the labor-intensive tax credit for TRASOP contributions, this problem would be magnified. Many of the companies which would take advantage of these provisions are closely-held and would be deterred from establishing a TRASOP (and thereby broadening its ownership base) because of a requirement that TRASOP stock be voted by participants. Therefore, the bill requires the pass-through of voting rights to participants only when the employer is a publicly-traded company (generally, a company which is reporting to the Securities and Exchange Commission under the Securities Exchange Act of 1934). This approach was first suggested in the staff report of the Joint Economic Committee on ESOPS which was issued in 1976.

In establishing the requirements which a TRASOP must satisfy in order to obtain the additional investment tax credit, the Tax Reduction Act of 1975 provided that a TRASOP, whether or not "qualified" under § 401 (a) of the Internal Revenue Code, would have to meet the minimum participation standards for qualified plans under Code § 410.8 Under § 410(b) (2) (A), employees covered by a collective bargaining agreement could be excluded provided that retirement benefits were the subject of good-faith bargaining between the employer and the

bargaining representatives. Since many TRASOPS were adopted during the term of existing collective bargaining agreements, some employers which adopted TRASOPS elected not to include union members as participants. In order to alleviate this apparent unfairness, the bill provides that all employees who are covered by a collective bargaining agreement will become participants in the TRASOP (subject to minimum age and service requirements) unless their bargaining representatives waive their right to participate in the TRASOP. The Committee Report on the bill is expected to expand upon this and point out that bargaining on the TRASOP issue will in no way reopen an existing collective bargaining agreement for bargaining on other issues.

Cash distribution option

In 1976, the IRS promulgated proposed regulations regarding ESOPs. These regulations contained significant problems which, if allowed to go unchanged, would have seriously curtailed the adoption of ESOPS by employers and the broadening of stock ownership among employees. In the Conference Report on the Tax Reform Act of 1976, Congress specifically instructed the IRS and the Department of Labor regarding the ways in which the proposed regulations were unsatisfactory. The agencies published final ESOP regulations in 1977 which generally alleviated the problems under the proposed regulations. However, in one critical area, the final ESOP regulations did not totally remove obstacles that acted as a deterrent to the adoption of ESOPs. These were the regulations regarding the granting of "put options" to employees who receive a distribution of ESOP stock acquired under ERISA's "ESOP loan exemption." The Department of Labor and the IRS felt, and justifiably so, that any participant who receives a distribution of stock of a closely-held corporation from an ESOP should have a market for the stock. This is an extremely critical point when an employee might well find himself holding employer stock for which there is no market at the time he is subject to income tax liability on his ESOP distribution. The agencies felt that the best solution for such a problem is to require that a closely-held employer grant a "put option" to the participant to resell his stock to the employer. In establishing this right, the final regulations contained very specific requirements regarding the duration of the put option, the terms for resale of the stock by the participant and other related matters. Many employers were concerned that the effect of these onerous put option regulations would be to make the leveraged ESOP unworkable for closely-held corporations. Accordingly, the bill provides that if the terms of the ESOP give each employee the option (prior to the distribution of benefits) of receiving cash in lieu of employer stock as his ESOP benefit, there would be no requirement that an employee who elected to receive stock be granted a put option. In this way, each employee is given the option to receive cash in lieu of stock and, therefore, is not faced with the problem of lack of marketability. This change would allow an ESOP to avoid the requirements for put options under the regulations and would simplify the administration of the ESOP, while at the same time offering employees the ability to "cash out" their ESOP shares. The bill provides such an employee election would not constitute the offering of a security under federal or state securities laws.

Charitable deduction

S. 3241 provides that an individual (or an estate or trust) will be eligible to claim a charitable deduction (for income, estate and gift tax purposes) for any "donation" to an ESOP. This would include an outright "gift" to an ESOP and a "bargain sale" to an ESOP. However, to assure that such deduction will not be providing a tax benefit for a transaction designed to benefit the donor (directly or indirectly), the bill establishes criteria which must be met in order for the deduction to be available. The donation to the ESOP must be allocated among participants in a nondiscriminatory manner. pursuant to Code § 401(a) (4). In addition, no part of the donation may be allocated to the donor or persons related to the donor under Code § 267 (b). Finally, no portion of the donation may be allocated to any other persons owning (directly or indirectly) more than 25 percent of any class of employer securities. This provision would create an alternative to traditional contributions to charity (or private foundatoins) for major shareholders and would be an incentive to provide stock ownership for employees.

Dividend deduction

S. 3241 would allow a tax deduction for dividends paid on employer stock held by an ESOP, provided that such dividends were "passed-through" to participants within sixty days after the close of the year in which paid. This provision would be limited to dividends on voting common stock). The purpose of this provision is to encourage ESOPS to provide participants with an immediate tangible benefit of stock ownership. Section 803 (h) of the Tax Reform Act of 1976 has made it clear that an ESOP could currently pay out such dividends to participants in cash. This provision of the bill would serve as an incentive to pay out dividends by providing a tax deduction to the employer.

Other tax changes

The bill also contains certain changes which affect employee benefit plans other than ESOPS and TRASOPS. Under the Tax Reform Act of 1976, a lumpsum distribution from a qualified plan is no longer eligible for the estate tax exclusion under Code §2039 (c). It is unclear whether the denial of the estate tax exclusion is applicable to any total distribution or whether it applies only to a distribution for which the special ten-year averaging provisions for income tax treatment is elected under §402(e).

In order to clarify this matter, the bill provides that the estate tax exclusion would be denied only when lump-sum distribution income tax treatment is elected under Code § 402 (e). In addition, the estate tax exclusion would be extended to a TRASOP not qualified under § 401 (a) to the extent applicable to qualified plans. In order to defer taxation on a lump-sum distribution through a "rollover" to an individual retirement account (IRA), any property (such as employer stock) received in the distribution must be "rolled over" in the same form as it is received. This requirement has created a problem with respect to distributions of employer stock from an ESOP. It is often difficult to find an IRA trustee willing to receive a rollover of employer stock, particularly if the stock is not publicly traded. In addition, an ESOP distributee frequently elects to resell stock received in a lump sum distribution back to the employer (or the ESOP) immediately, often pursuant to the put option granted at the time of distribution. However, under existing law if the participant were to resell his shares of employer stock he is not permitted to roll over the cash proceeds from the sale to an IRA and thereby defer tax on the distribution. Therefore, the bill provides that an employee may resell employer stock to the employer or to the ESOP (or other plan) and still defer taxation on the distribution by rolling over the cash proceeds of the sale to an IRA. In addition, the bill provides that an employee who elects to receive cash in lieu of employer stock from an ESOP will also be able to transfer the cash distribution as a rollover contribution to an IRA.

S. 3241 also provides that participation in a TRASOP (whether or not “qualified") would not preclude deductible IRA contributions by the participant under Code §§ 219 and 220. If the participant did not participate in any other plan qualified under § 401 (a), he would still be entitled to contribute to an IRA. This provision would remedy the problem of participation in a TRASOP (possibly representing a small percentage of pay) denying the opportunity for retirement savings by an individual through an IRA.

Under existing Code § 402 (e), a participant who receives a distribution from a qualified plan which constitutes a "lump-sum distribution" may elect to take advantage of the ten-year forward averaging provision available for such a distribution. However, if the distribution to the participant includes employer securities which have appreciated in value during the time that they were held by the plan, the participant is taxed only on the plan's cost basis for such securities. The appreciation will be taxed as long-term capital gain upon subsequent disposition. In the event of an immediate resale of the securities, total tax liability will be a combination of ten-year averaging and capital gain treatment. In many cases, this results in greater tax liability than if the entire value of the distribution were subject to ten-year averaging. In order to alleviate this increased tax burden and to provide greater simplicity in calculating the tax liability on a lump sum distribution including employer securities, the bill would allow an election to the recipient to treat the entire distribution (including appreciation in value of employer securities) as ordinary income for purposes of § 402(e) and the ten-year

• Code § 402(a) (5).

averaging provisions. This is similar to the election added in Code § 402(e) (4) (L) in 1976 to allow ten-year averaging with respect to pre-1974 participation.

Under the Tax Reform Act of 1976, an employer which makes a TRASOP contribution and which later recaptures a portion of this investment tax credit, may, if the TRASOP has allocated contributions to separate segregated accounts, recapture a portion of the stock from the TRASOP.10 It is also worth noting that the employer would have the option of leaving the stock in the TRASOP and simply taking a deduction for that portion of the contribution which is reflected by the recapture. However, assuming that the employer wished to actually recapture any stock from the TRASOP, a problem is presented for participants. This is because the participant must receive his entire distribution within a single year in order to be eligible for the beneficial tax treatment on lump-sum distributions." Any amount held in the segregated account would probably not be distributed to him at that time, resulting in the loss of lump-sum distribution treatment for a significant number of employees. Therefore, the bill provides that if such a situation exists and the TRASOP is holding stock for its participants in segregated accounts subject to recapture, an employee who receives a distribution of the remaining portion of his benefit under the TRASOP will still be eligible to elect lump-sum distribution treatment on that portion. Any amount later distributed to him from a segregated account will simply be treated as ordinary income. However, the beneficial tax treatment which attaches to a lump-sum distribution will be eligible for the initial distribution.

Under present law,12 any reduction in taxes which occurs as the result of a credit claimed under Code § 38 may result in increased liability for the minimum tax on tax preferences. Since the TRASOP tax credit is claimed as a result of the investment tax credit provided by § 46 of the Code, its actual basis for claim is § 38. Therefore, if an employer received no net benefit from the reduction of taxes by reason of the TRASOP contribution offsetting its tax savings, it might find itself paying an increased minimum tax. For this reason, the bill adds back the credit for a TRASOP contribution (the additional investment tax credit or the tax credit based on payroll) to the regular tax computation for purposes of determining liability for the minimum tax under § 56.

With the exception of the minimum tax relief provided by the bill, all sections of the bill will generally be effective for taxable years beginning after December 31, 1977. Because the problems created by the minimum tax on tax preferences would have dated back to the effective date of the Tax Reduction Act of 1975, the effective date of that section is for all plan years beginning after Decem ber 31, 1974.

Increase in ESOP contribution limits

On July 14, 1978, Senator Mike Gravel introduced S. 3291 to propose an additional incentive for ESOPs. Under S. 3291, the deduction limits under Code § 404 (a) and the allocation limits under Section 415 (c) for ESOP contributions would be increased from 25 percent of covered payroll to 50 percent of covered payroll. These increased limits would be subject to the restrictions on allocations to officers, shareholders and highly-compensated employees included in existing Code § 415 (c) (6).

Conclusion

S. 3241 and S. 3291 demonstrate the interest of the Senate Finance Committee in providing increased incentives for the adoption of ESOPS to allow for greater "ownership-sharing" opportunities for employees. On July 19-20th, the Finance Committee held ESOP hearings to consider these bills and other matters relating to ESOPS. It may be expected that action on these bills will occur sometime this year and that ESOPS will continue to be encouraged by Congress.