Kelso, ERISA, and the Modern ESOP

President Ford Speaking at the ERISA Signing Ceremony

August 31, 2024 Richard Harmon

In the 1950’s, economist and attorney Louis Kelso began advocating for business owners to create meaningful equity opportunities for their employees. Kelso believed this form of shared capitalism could create a more level playing field in society and help more workers thrive economically and benefit from a capitalist economy.

“The Roman arena was technically a level playing field. But on one side were the lions with all the weapons, and on the other the Christians with all the blood. That's not a level playing field. That's a slaughter. And so is putting people into the economy without equipping them with capital, while equipping a tiny handful of people with hundreds and thousands of times more than they can use.”

 

—Louis O. Kelso, in Bill Moyers, “A World of Ideas II, Public Opinions from Private Citizens.”

 

The Capitalist Manifesto

In 1958, Kelso co-authored The Capitalist Manifesto with philosopher Mortimer Adler. A seminal text in employee ownership circles, their book presents a formal structure for equity participation by workers: the employee stock ownership plan.

"It was a bestseller," notes Corey Rosen, founder of the National Center for Employee Ownership (NCEO). "It started to get quite a bit of attention at the time."

Over the next decade, Kelso actively socialized the ESOP with business leaders and legislators. He understood that widespread adoption of employee ownership likely hinged on recognition in the Internal Revenue Code and related tax incentives.

After years of limited progress, Kelso secured a breakthrough in 1973. Congress was holding hearings on saving the US’s troubled freight rail system. There were calls on Capitol Hill for industry companies to share equity with employees.

Key congressional staffers recognized the potential utility of employee stock ownership plans and started circulating Kelso’s concept. Senator Rusell B. Long, head of the Senate Finance Committee, took notice. On November 26, 1973, the two men met for nearly four hours. Afterwards, Long was sold employee ownership.

Less than a year later, the powerful senator helped enshrine ESOPs in a piece of landmark legislation.

 

The Employee Retirement Income Security Act of 1974

On Labor Day 1974, President Gerald Ford signed ERISA into law. A transformative bill for American workers, the bipartisan legislation set standards for most private, voluntarily established retirement and health plans, including 401(k)s and IRAs. In addition to these critical protections, ERISA codified ESOPs and authorized these plans to borrow money and purchase shares from a sponsor company (also known as a leveraged ESOP).

Initially, sponsor companies could only make tax-deductible ESOP contributions equivalent to 15% of their eligible annual payroll. No additional tax advantages were afforded to stakeholders. But in time, that would change. Thanks to ensuring support from legislators from both the pro-business and pro-worker camps, ESOP incentives would evolve. 

 

Notable ESOP Legislation

Just one year after the passage of ERISA, Congress approved the first amendment to the modern employee stock ownership plan. That legislation kicked off a relatively continuous process of tax code and regulatory tweaks, leading up to today.

Tax Reduction Act of 1975

Provided 1% tax credit for qualifying capital investments if company contributed equivalent stock to an ESOP (TRASOP).

The Revenue Act of 1978

Created Section 409(A) of ERISA, requiring that ESOP shares be subject to a fair market valuation (FMV). These valuations, performed by an independent appraiser, are a critical step in both plan formations and ongoing maintenance.

The Tax Reform Act of 1984

Created notable financial incentives, including tax-deductible employee dividends and 1042 rollovers. That latter permits a company’s owners to defer or eliminate capital gains burdens on their ESOP sales proceeds by investing in qualified replacement properties (QRPs).

Small Business Job Protection Act of 1996

Prior to this bill, only C corporations could form ESOPs. The SBJPA opened the door to ESOP-ownership of S corporations and one of the most consequential employee ownership tax advantages.

Consider a 100% ESOP-owned S corp. Any K-1 income passes through to a tax-employee stock ownership trust (ESOT). Because an ESOT isn’t subject to federal or most state income taxes, an S-ESOP can effectively function as a tax-exempt entity in perpetuity.

Economic Growth & Tax Relief Reconciliation Act of 2001

Increased annual ESOP contribution percentage from 15% to 25% of eligible pay. This enabled sponsor companies to more rapidly fund their ESOP plans and take associated corporate income tax deductions.

American Jobs Creation Act of 2004

Enacted Internal Revenue Code Section 409(p), which, among other things, permitted ownership of synthetic equity—including options, warrants, and stock appreciation rights—in an ESOP-owned S corp structure. As a result, a 100% S-ESOP can still maintain its income tax-free status, while parties outside of the employee trust continue to hold synthetic equity (and maintain potential upside) in the company.

SECURE 2.0 Act of 2022

Until 2022, 1042 reinvestment was only afforded to selling shareholders of ESOP-owned C corps. SECURE 2.0 modestly extended the capital gains tax deferral benefit to S corps. If a sponsor company closes its ESOP transaction as an S corp, sellers can now reinvest up to 10% of their proceeds in an QRP.

SECURE 2.0 also directed the Department of Labor to codify certain ESOP compliance rules and promote employee ownership through nationwide initiatives. National advocacy organizations, including the National Center for Employee Ownership and the ESOP Association, believe the latter will have a profound impact on ESOP awareness and adoption in the US.

 

Employee Ownership’s Future

In the five decades since the modern ESOP’s establishment, these defined contribution plans have been embraced as robust M&A alternatives. Today, there are over 6,500 ESOPs, covering nearly 11 million active participants.

As the Silver Tsunami, the conscious capitalism movement, and a growing appreciation for independent business continue to influence the market, ESOP adoption is expected to rise. While Kelso’s dream of widespread employee ownership has not been fully realized, if history is a guide, the future of ESOPs looks promising.

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