Updated ESOP Loan Default Rates, Shortened Built-In Gains Tax Holding Period
The September 30, 2010 Employee Ownership Update is online and discusses the following:
- Very Low Default Rate for ESOP Loans
- Small Business Jobs Act of 2010 Temporarily Shortens Built-In Gains Tax Holding Period
- Looking for Burn Rates?
Last year we discussed the 2008-2009 Business Transition Loan Default Rates (ESOP Loans: < .5%, Private Equity: 19.4%). The Update provides updated estimates for 2009-2010 and discusses why ESOP loan default rates are significantly less than private equity loan default rates:
For the 2009-2010 period, the estimated defaults typically ranged between 1% and 2%, but some providers reported no defaults and one reported that 15% had defaulted. For the prior period, ESOP defaults were vanishingly small. Almost all these providers have at least 10 years of experience in the field. Annualizing their estimates would result in rates well under 0.3% per year, or about 1% to 2% over the whole time period, again with a few exceptions. One of the largest plan administration firms in the country actually calculated the rate for its hundreds of clients and found that it was 0.13% annually.
Making comparisons with non-ESOP data is tricky. A 2010 Moody's study found that of 186 private equity owned companies, 19.4% defaulted between January 2008 and 2009. Prior Moody's data from 2006 found a 14.2% rate for Ba-rated firms and 42.9% for B-rated firms (there were no data for firms with better ratings). The Private Equity Council, however, used a different definition of default by excluding debt-swaps, which Moody's called defaults. They reported a default rate of 2.8% in 2008 for private equity-backed companies and 6.2% for companies in general for LBOs. Prior research has arrived at similarly wildly different numbers.
These studies are also limited in that they typically rely only on public company LBOs. Moreover, ESOP law prevents lenders to ESOPs where a loan payment is missed from accelerating the debt and creating a full default. For this and other reasons, ESOPs are more likely to restructure troubled loans than just give up on paying them. Many ESOP loans are also seller notes, adding another layer of complexity. Finally, although the providers probably service as much as half of all ESOPs, we cannot be sure that they are representative of the universe of ESOP companies, and, conceievably, could overrepresent more successful ones.
The Update also discusses how Section 2014 of the Small Business Jobs and Credit Act of 2010 temporarily shortens the built-in gains (BIG) tax holding period (the period that all built-in realized gains from converting to S Corporation are taxed on Form 1120S) to five years:
SEC. 2014. TEMPORARY REDUCTION IN RECOGNITION PERIOD FOR BUILT-IN GAINS TAX.
(a) In General- Subparagraph (B) of section 1374(d)(7) of the Internal Revenue Code of 1986 is amended to read as follows:
'(B) SPECIAL RULES FOR 2009, 2010, AND 2011- No tax shall be imposed on the net recognized built-in gain of an S corporation—
'(i) in the case of any taxable year beginning in 2009 or 2010, if the 7th taxable year in the recognition period preceded such taxable year, or
'(ii) in the case of any taxable year beginning in 2011, if the 5th year in the recognition period preceded such taxable year.
The preceding sentence shall be applied separately with respect to any asset to which paragraph (8) applies.'.
(b) Effective Date- The amendment made by this section shall apply to taxable years beginning after December 31, 2010.