The SECURE 2.0 Act of 2022 (SECURE Act 2.0) makes far-reaching changes to the US retirement plan system. Our initial SECURE Act 2.0 LawFlash provided a general overview of its significant provisions. This blog post—one in our series of coverage on SECURE Act 2.0—focuses on provisions unique to employee stock ownership plans (ESOPs).
Of specific interest to ESOP sponsors and ESOP sellers, SECURE Act 2.0:
- amends Section 1042 of the Internal Revenue Code of 1986, as amended (the Code) to permit a 10% tax deferral for certain sales to S Corporation ESOPs;
- amends Section 401(a)(35) of the Code to change the definition of “publicly traded” for certain diversification purposes;
- directs the Department of Labor (DOL) to create an Employee Ownership Initiative and release formal guidance in connection with the Employee Ownership Initiative; and
- directs the DOL to release formal guidance on good faith fair market valuation standards.
10% Tax Deferral for Sellers to S Corporation ESOP
Section 114 of SECURE Act 2.0 amends Section 1042 of the Code to extend to S corporation owners a tax deferral opportunity previously available only to C corporation owners. Prior to SECURE Act 2.0, Section 1042 of the Code permitted an owner of stock in a non-publicly traded C corporation to defer capital gains tax on up to 100% of proceeds from a sale to an ESOP if certain requirements are met, such as (1) the ESOP owns 30% or more of the stock after the sale and (2) the seller reinvests the proceeds in stocks and bonds of US operating companies (referred to as “qualified replacement property”).
For sales to ESOPs that occur after December 31, 2027, S corporation owners can now take advantage of Section 1042 of the Code, but with a limit of 10% of proceeds for purposes of deferring the amount of gain.
Limited Change in Definition of ‘Publicly Traded’
Section 123 of SECURE Act 2.0 amends Section 401(a)(35) of the Code to expand the definition of “publicly traded security” for purposes of certain Code diversification provisions. Effective for plan years beginning after December 31, 2027, an employer security will be treated as “publicly traded” for diversification purposes under Section 401(a)(35)(G)(v) (which currently defines “publicly traded employer securities” as “employer securities that are readily tradable on an established securities market”) if it:
- is subject to priced quotations by at least four dealers on a US Securities and Exchange Commission–regulated interdealer quotation system (as defined in Section 13 of the Securities Exchange Act of 1934);
- is not a penny stock;
- is not issued by a shell company, blank check company, or subject to bankruptcy proceedings; and
- has a public float which has a fair market value of at least $1,000,000 and constitutes at least 10% of outstanding shares.
If a security that meets the above requirements is issued by a domestic corporation, that corporation must publish audited financial statements at least annually for the security to be considered “publicly traded” under this amendment. If the security is issued by a foreign corporation, that security must either (1) be represented by a depositary share or (2) be issued by a foreign corporation incorporated in Canada that meets additional requirements specific to Canadian issuers and be readily tradable on an established securities market in Canada.
Interestingly, the Senate Finance Committee's December 2022 summary of the SECURE Act 2.0 Act does not appear to limit the applicability of this amendment to the diversification rules that the text of the amendment addresses. Instead, the Senate Finance Committee’s summary specifically notes that the intention of this amendment is to update ESOP rules related to whether a security is a “publicly traded employer security” and “readily tradeable on an established securities market.” The summary elaborates that the goal here is to allow highly regulated companies with securities that are quoted on non-exchange markets to treat their stock as “public” for ESOP purposes, thus making it easier for these companies to offer ESOPs to their US employees.
Whether Congress will expand this language to apply to more than just the Section 401(a)(35) diversification rules (e.g., to eliminate the annual independent appraisal requirement under Section 401(a)(28)(C) of the Code for companies covered by the amendment’s text) remains to be seen.
The Employee Ownership Initiative
Section 346 of SECURE Act 2.0 contains the Worker Ownership, Readiness, and Knowledge Act (WORK Act), which requires the DOL to establish an Employee Ownership Initiative to promote employee ownership at the state level. The WORK Act contemplates that this program will initially have $4 million of funding in fiscal year 2025, and the funding will gradually increase to $16 million by fiscal year 2029.
The WORK Act demonstrates congressional support for employee ownership and directs the DOL to implement the Employee Ownership Initiative by making state-level grants, by acting as a clearinghouse on techniques employed by new and existing programs and existing state-level programs, and by funding projects for information gathering on those techniques by groups outside the DOL.
Formal Guidance on ESOP Valuation Standards
The WORK Act also requires the DOL to 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.” This directive from Congress is meant to fill a regulatory gap in the prohibited transaction rules set forth in the Employee Retirement Income Security Act of 1974, as amended (ERISA). Under ERISA Section 408(e), an ESOP’s purchase of its sponsoring company’s stock is exempt from ERISA’s prohibited transaction rules only if the ESOP pays no more than “adequate consideration” for the stock, which ERISA defines as the:
“Fair market value of the asset as determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with regulations promulgated by the Secretary [of Labor].”
While members of the ESOP community have been urging the DOL to release guidance on this point for years, the only formal regulatory activity to date has been in the form of Proposed Labor Regulation Section 2510.3-18, which was released in 1988 but never finalized.
We will be watching the DOL closely on this regulatory initiative and will supplement this blog as information becomes available.