For over 20 years, Congress has provided powerful incentives for S corporations to sponsor employee stock ownership plans (“ESOPs”) through the tax code provisions that exempt all of the income of a 100% ESOP-owned S corporation from federal income tax. At the end of last year, Congress struck again to specifically encourage 100% owned S-corporation ESOPs to be formed.
Section 874 of the National Defense Authorization Act (“NDAA”) signed into law by President Biden on December 27, 2021 created a pilot program that would allow companies that are or become a “qualified business wholly-owned through an employee stock ownership plan” and which bid on contracts procured by the United States Department of Defense to qualify to bid on “follow-on contracts” without going through a competitive bidding process. The statute defines a “qualified business wholly-owned through an employee stock ownership plan” as a 100% ESOP-owned S corporation.
This new program would not benefit a firm that is not already doing business with the U.S. Department of Defense because it only references the ability to obtain one single “follow-on contract” (i.e. a new contract for services that are the same or substantially similar to a contract that the company performed before they were a 100% ESOP-owned S corporation). However, for qualified firms, there may be further bidding opportunities if a “senior contracting official” approves the firm to get more than one “follow-on contract”.
There is also a restriction that would prevent sub-contracting more than 50% of the value of the contract, so if any of these firms rely on sub-contractors, they will have to change their practices. However, in three years, the Comptroller General will be required to submit a report to Congress to extend the pilot program so these limitations may change at some point.
Despite these limitations, the fact that Congress established the first-ever government contracting program to specifically encourage ESOPs is a strong signal that ESOPs are here to stay as an effective and powerful business succession strategy.
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