ESOP Legislative History
CRS Report for Congress
Received through the CRS W eb
Emp l o yee Sto c k O w n ersh ip Plan s ( ESOPs):
Legislative History
ToddS.Snyder
Presidential Management Intern1
American Law Division
Summary
Employee Stock Ownership Plans ( E S O P s ) a r e d e f i n e d c o n t r i b u t i o n p lans primarily
i n v e s t ed in the employer’s securities. Employee stock plans in the form of an ESOP
pre-date the 197 4 E m ployee R etirem ent Income S ecurity Act (ERIS A).2 ERIS A,
however, was the first law t o recognize ESOPs. C ongress has routinel y revisited ESOPs
and amended t he IR C t o reflect policy. The 1975 Tax R eduction Act created a t ax credit
for ESOPs. The Revenue Act o f 1978 added n ew formalities t o ESOPs through creation
of IR C § 409A. In t he mid-1980s, t he 1984 Tax R eform Act created new and substantial
tax i ncentiv es fo r e m p loyers maintaining ESOPs for employees. Two years l at er, t he
1986 Tax R eform Act emphasiz ed t he retirement objective of ESOPs by impos i n g a
10% penalty tax o n withdrawals m ade p ri o r to age 59.5. The Omnibus Budget
Reconciliation Act of 1989, however, repealed or limited m ultiple ESOP tax i ncentives.
T h e S mall Bu siness J o b P rotection Act (S BJ PA) o f 1996 widened t he availability o f
ESOPs b y allowing S corporation s hareholders t o part i ci p at e. To prevent abus e o f S
corporation ESOPs, t he Economic Growth and Tax Relief R econciliation o f 2001 Act
initiated a 50% ex ci se tax on prohibited allocations by S corporation ESOPs. Finally,
the J ob Creation and Worker Assistance Act o f 2002 increased the contribution limits
of many qualified retirem ent plans, i ncluding ESOPs.
Currently, an estimated 10 million employees p a rticipat e i n Employee S tock
Ownership P l ans (ES OP s).3 ESOPs are defined contributio n plans primarily invested in
the employer’s securities. Thes e plans are believed t o further motivat e employees since
t h ei r fi n anci al i n t erest s are m o re di rect l y l i nked t o t hei r em pl oyers. Bot h em pl oyees and
em ployers benefit from certain tax advantages . In addition t o providing em ployees with
1 T his report was produced under t he general s upervision of M arie Morris, Legi slative Attorney.
2 P.L. 93-406.
3 CRS Report RL30038, ESOPS: A Description and Economic Analysis,byGeraldMayer.
Congressional Research Service ˜ The Library of Congress
ret i rem ent b enefi t s and addi t i onal w ork i ncent i v es, E S O P s can a l s o s e r v e a v ari et y of
corporat e fi n ance obj ect i v es i n cl udi ng capi t al form at i o n and great er cash fl o w. Today,
an ESOP must satisfy the requirements o f bot h Internal R evenue Code (IRC) § 401(a) and
IR C § 4975(e)(7). 4
Employee stock p lans in t h e form o f an ESOP p re-date t he 1974 Employee
R et i rem ent Incom e S ecuri t y Act (ER IS A). 5 ER IS A, however, w as t h e fi rs t l aw t o
recogn i z e E S OP s and m odi fi ed t h e IR C t o refl ect ed ES OP provi si ons. 6 ERIS A was
passed i n order to protect the i nteres ts of participants and beneficiaries of pension plans
in the private sect or.7 This legi slation responded t o i nst a n c es where p ension funds had
been underfunded, we n t insolvent, or had b een mishandled. 8 Viewed broadly, the
legi slative purpose was to provide employees with a s ource of retirement i ncome, ex pand
employee stock o wnership, and to grant bus inesses a tax -favored method of financing.9
An early proponent of ESOPs, Louis Kelso, b elieved t hat ESOPs would raise the i ncomes
of lower-income families t hrough a more equal distribution of income-producing capital.10
Also, t hrough employer and em p l oyee shared tax advantages, ESOPs would i ncrease
aftertax lifetime income.
Congress has routinel y revisited ESOPs an d amended t he IR C t o reflect policy. The
Tax R eduction Act of 1975 created a corporate t ax credit for E SOPs.11 Thi s 11% credi t
was available t o t he corporate t ax payer with respect to qualified i nvestment where at l eas t
one percent o f t he qualified i nvestment is contributed to an ES OP . C ongress at t ached
conditions to this temporary credit 12 incl uding immediat e ves ting for em ployee
participants and a seven-year distribution m orat orium. Shortly thereafter, the Tax Reform
Act o f 1976 13 provided for employee stock options (whether or not they qualified under
th e IRC) granted after May 20, 1976 to be governed by the ex i sting t ax treatment of
nonqualified s tock options. 14
4 See also IRC § 409.
5 P.L. 93-406, amending IRC § 401, § 72, and § 46 a mong others and a dding IRC § 4972, § 6057,
§ 6058, and § 6059 among others.
6 CRS Re p o r t RS20686, Employee Stock Ownership Plans (ESOPS) and S Corporations:
Proposals i n 2000, by David L. Brumbaugh.
7 CRS Report RL31507, Employer Stock i n Retirement Plans: I nvestment Risk and Retirement
Security, by Patrick J . Purcell.
8Id.
9 Brumbaugh a t 1. See also Senate Committee on t he Budget. Tax Expenditures. Compendium
of Background Materia l s on I ndividual Provisions . Prepared by t he Congressional Research
Service. Washington, U.S. Govt . Print. Off. 1998. p. 379-380.
10 K e lso, Louis O. Readings in Binary Economics: The Foundation of t he ESOP. 1988. p.44-46.
11 P.L. 94-12, amending IRC § 46.
12 T his credit was available f or qualified i nvestment made between J anuary 22, 1975 and
December 31, 1976.
13 P.L. 94-455, amending IRC § 422.
14 Id. a t § 603.
The R evenue Act o f 1978 added n ew forma lities t o ESOPs through creation of IRC
§ 409 A . 15 This section, titled Qualifications for ESOPs, articulat ed definitions and
requirements for a p lan t o qual i fy as a “Tax C redi t ES OP .”16 On a related note, the 1978
A c t also formaliz ed 401(k)s t hrough crea tion o f IRC § 401(k). The year 1981 bro u g h t
passage of the E conomic Recovery Tax Act (ERTA). 17 The ERTA s upported ESOPs
through increasing the deduction limits applicable to em ployer contributions used to repay
a l oan m ade from an E S OP . As previ ousl y not ed, E S OP s al so serve corporat e fi n anci al
objectives that other employee b enefit plan s cannot, s uch as t he ability to take out loans
from t he plan. P rior to 1981, some corporations were leveragi ng ESOPs b y combining
them with a m oney purchase p ension plan. This h ad the effect of raising t he deductible
limits on em ployer contributions from 1 5 % to 25%. P assage of ERTA eliminat ed the
need for t hi s s t rat egy.
In the mid-1980s, t he 1984 Tax R eform A c t c r e a t ed new and substantial t ax
incentives for employers maintaining ESOPs for employees .18 Notably, employers were
allowed d eductions for d ividends paid in cash under a qualifyi ng ESOP.19 Also, IRC §
133 was creat ed to permit qualified financi al institutions to ex cl ude 50% of the i nteres t
on loans t o ESOPs.20 Tw o ye a r s l ater, t he 1986 Tax R eform Act emphasiz ed t he
retirem ent objective of ESOPs by imposing a 10% penalty tax o n withdrawals m ade p rior
t o a ge 59.5, discouraging p remature withdrawals. 21 The year 1988 brought cer t a i n
technical corrections to the 1986 Act, articulating what t ransactions qualify for deferral
of recogn ition o f gain, clarifyi ng that the nonallocation p eriod b egins o n t he date of the
sale of securities and ends on the l at er of 10 years or t he date of th e p l a n a l l o cation
attributable to the final paym ent of acquisition i ndebtedness. 22 A l so, t he 1988 Act
cl ari fi ed t he el ect i o n ri ght s o f e m p l o ye e s who w ere at l east age 55 and h ad 10 years o f
service t o diversify thei r plan. 23 This ability to diversify holds particular importance i n
today’s climate of stock val ue fluctuations.
15 P.L. 95-600, § 141.
16 Id. at § 141(o)(3).
17 P.L. 97-34.
18 P.L. 98-369.
19 P.L. 98-369 § 542, amending IRC § 1042.
20 Id. a t § 543.
21 P.L. 99-514. T his 10% tax i s i n a ddition t o t he norma l f ederal income tax on distributions from
aqualifiedplan.
22 P.L. 100-647.
23 P.L. 100-647, § 1011, amending IRC § 401(a)(28).
In an effort t o creat e revenue gai n s, 24 the Omnibus Budget Reco nciliation Act of
1989 repealed or limited m ultiple ESOP tax i ncentives. 25 The IR C § 133 ex cl usi o n h ad
new rest ri ct i ons pl aced on i t , added p l an report i n g requi rem ent s, pl ace d a d d i t i onal
restrictions on deductible dividends paid to employees, and repealed IR C § 2057 which
pertai ns to an estate tax deduction for certain em ployer securities sal es to ESOPs.26
T h e S mall Bu siness J o b P rotection Act (SBJ PA) o f 1996 widened t he avai l a b ility
of ESOPs by allowing S corporation s h a r eholders to participate. 27 S corporations are a
t ype of corporat i on, posses s i n g n o m o re t h an 75 sharehol ders, t hat i s accorded t ax
treatment different than trad itional (“C”) corporations. 28 C o n gressional m otivation for
this provision was t o encourage employee o wnership of closely-held businesses.29 This
Act also repealed IR C § 133, eliminating t he ab ility of lenders to ex clude from t heir gross
income 50% of the i nterest earned o n a loan to an ESOP or to an employer sponsoring an
ESOP.30 One m otivation for repealing t he interest ex cl usion was that the J oint Committee
on Tax ation estimated t hat $505 million additional t ax dollars would b e added t o revenues
for t he ensuing five fiscal years . 31 Other revenue motivated provisions incorporated in
this 1996 Act i nclude applyi ng the Unrelated Bu siness In come Tax (UBIT) t o an ESOP’s
share o f S -corporation earnings.32
The application o f t he UBIT tax d i d n o t l ast long, as i t was repealed as part of the
Tax p ayer Relief Act of 1997. 33 Congress was concerned about possible double t ax ation
of S corporation ESOPs, conceivable s ince al l S corporation i ncome i s s ubject to tax ation
at the s hareholder l evel in addition t o t he short-lived UBIT tax . 34 To address these
concerns, t he 1997 Act allowed S corporation ESOPs to distribute cash t o plan
24 T he 1989 Act was expected to ge n e r ate $8.45 billion f or the i nclusive fiscal years 1990 to
1994. U.S. Congress. J oint Committee on T axation. Estimated Revenue Effects of Conference
Agreement on Revenue Provisions of H.R. 3299, the Omnibus Budget Reconciliation Act of 1989 .
J CX -74-89, Nove mb er 21, 1989.
25 P.L. 101-239.
26 P.L. 101-239, § 7301- § 7304.
27 P.L. 104-188.
28 F o r e xample, S corps do not pay c orporate i ncome t ax on their net income (in other words,
income from a n S corporation allocable to an ESOP is not subj ect t o i mmediate t axation), but
they are not allowed t ax deductions for s tock divi dends.
29 Senate Report 104-281, p.66.
30 P.L. 104-188, § 1602. See Senate Report 104-281, p.114.
31 U.S. Congress . J oint Committee on T axation. Estimated Budget Effects of Conference
Agreement on H.R. 3448, Small Business J ob Protection Act of 1996. J CX -47-96. Augu st 1,
1996. p.5. $505 million i s a collective a mount for t hose f is c a l ye a r s . See also Senate Report
32 House Report 104-737, p.231.
33 P.L. 105-34, § 1523.
34 House Conf. Report 105-220, p.745.
p a rt icipants35 andextendedanexceptiontoScorporation ESOPs previously only
available t o t raditional ESOPs.
Congress continues its routine ex amination and alterations to the operation and
requirements o f ESOPs. In 2001, the Econo mic Growth and Tax Relief R econciliation
Act addressed t he Congressional concern o f i nappropriate tax d eferral opportunities for
S corporat i o n E S O P s and i n s t a n ces wher e S corporation ESOPs were primarily
benefitting only t he hi gh l y co mpensated employees.36 Consequently, t his 2001 Act
initiated a 50% ex ci se tax on prohibited allocations by S corporation ESOPs. S imilarly,
individuals who o wn 10% of the s hares, or deemed part of a 2 0 % “ s hareholder group”
(individual and family members t oget her) will be considered a “disqualified person” and
merit a 50% ex cise tax o n any synthetic equity37 the disqualified person owns. Also, t his
Act i ncreas ed the contribution limits of many qualified retirem ent plans, i ncluding
ESOPs . 38 M o st recently, t he J o b C reation and W o rker Assistance Act o f 2002 made
certain technical revisions to the 2001 Act, such as amending provisions for catch-up
contributions and v esting s tandards.39
Conclusion
Since formal recognition of ESOPs, C ongres s has continually ex amined and
modified the t ax treatment of ESOPs and adjusted the qualification requirements. From
initially seeking t o recognize a new method of retirem ent savings that businesses had
gotten behind, to d a y C o ngres s s trives to balance t ax policy objectives , t he need for
corporate s upport, revenue concerns, abuse p revention, and l ong-term fiscal security for
employees.
35 Note that the employee must have r ight to require the employer t o purchase t he securities.
36 P.L. 107-16.
37 A synthetic equity refers to any stock option, warrant, r estricted stock, deferred i ssuance stock
rights, or similar i nterest.
38 P.L. 107-16, § 611, amending IRC § 415.
39 P.L. 107-147, amending IRC § 411 and IRC § 414 among others.