Statement of Delores L. "Dee" Thomas, Vice President,
Ewing & Thomas, Inc., and Vice Chair, the ESOP Association

Testimony Before the House Committee on Ways and Means

Hearing on Revenue Provision in President's Fiscal Year 2000 Budget

March 10, 1999

Thank you. My name is Delores L. "Dee" Thomas. I am Vice President of an independent physical therapy company, Ewing & Thomas, Inc. located in New Port Richey and Sebring, Florida.

Important for today's hearing is the fact that Ewing & Thomas is the only physical therapy company in America operating as a 100% employee-owned company, through an employee stock ownership plan, or ESOP. Ewing & Thomas is also an S corporation. There are 38 employee owners at Ewing & Thomas, which is nearly all of our current employees.

Today, I testify not only on behalf of the employee owners of Ewing & Thomas, but also for The ESOP Association, a national 501(c)(6) association with over 2000 members representing nearly1 million employee owners.

My purpose is to express the ESOP community's opposition to the revenue raising proposal in the Administration's proposed budget to repeal a 1997 law that has proven to be a needed incentive for the creation and operation of companies which are 100%, or near 100% employee-owned companies. The proposal is set forth on page 110 of the Treasury Department's so-called "Green Book" describing the Administration's revenue raising proposals in the Fiscal Year 2000 budget.

I ask your indulgence as I make a few general remarks. I do so because in the employee ownership world our focus is on the long-term, not the short-term.

We believe that significant employee ownership does improve the performance of a corporation, and just as important does maximize human potential and self-dignity of all employees as they share in the wealth they help to create.

Our beliefs are backed-up by solid evidence, such as a recent study by Dr. Melhad of Northwestern University's Kellogg of Business and Management, which reviewed the performance of over 400 companies over 4 years. Attachment 1 to this statement is a synopsis of the research conducted over the past 15 years that supports our beliefs.

I am very active in The ESOP Association, nationally, and in our Florida Chapter. On May 1, I will become the Chair of the Association, our highest elected office.

But clearly I can testify best about employee ownership through the experience as an executive of Ewing & Thomas.

In 1987, Mrs. Ewing and I, who started our independent firm in 1969, faced the potential demise of our company, as Mrs. Ewing had reached an age where she did not want to practice each day, and I had a serious illness. We needed an exit strategy, but were afraid of what would happen to our employees and our community involvement if we sold out to a large national or regional chain. Fortunately, Congress has provided a wonderful alternative--selling to the ESOP for the benefit of the employees.

Did we take advantage of the tax laws favoring exiting shareholders of closely-held companies? Yes, we did. Did we have to pay high fees to lawyers, valuators, administrators, and accountants to make the ESOP happen, so that the complex ESOP laws would be honored to protect the employees? Yes, we did.

But let me emphasize, the ESOP is more than laws and regulations to our employees. It has become their way of life.

For example:

• We have employee owners from all levels on our six-person Board of Directors.
• We have employee owners participating in decision-making at all levels.
• We share and discuss all of our financial information with all employee owners.
• It was a joint decision that our company has sent ten needy employee owners to college to better themselves and our company.
• Each day incredible unselfish acts are performed by this group of employee owners.
• We all participate in state and local meetings where we share our ESOP experience and learn from other employee-owned companies.

Attachments 2 are articles recognizing Ewing & Thomas as a special place to work.

If you do not believe me, or the articles, ask your colleague Congresswoman Thurman, who has visited on several occasions with our employee owners.

And if you don't believe me, Congresswoman Thurman, or the newspapers, ask Alphonso Maxime or Gary Walz, employee owners from Ewing & Thomas now standing. They will be more than willing to speak with you or your staff about employee ownership, and their experience at Ewing & Thomas.

Is Ewing & Thomas unique? No.

When I think of employee ownership I think of Bimba Manufacturing in Illinois; Reflexite in Connecticut; Austin Industries in Texas; Acadian Ambulance in Louisiana; the Braas Company in Minnesota; and the list goes on and on.

Many members of this Committee know these companies and their employee owners up close and personal.

This Committee has a basic choice.

The Committee can accept the Administration's proposal, and take a stand to retard the expansion of employee ownership; or this Committee can reject, or significantly alter the Administration's proposal, and take a stand with the employee ownership community.

Clearly, we must respond to the specific proposal from the Administration, and explain why its enactment would retard employee ownership growth; but keep in mind, if you want employee ownership to grow, as practiced in the companies I've cited, then you will discard the Administration's proposal.

To summarize the Administration's proposal: The proposal is designed to raise taxes by imposing on an S corporation an unrelated business income tax, or UBIT, on the ESOP's share of the income of that corporation. The proposal goes on to provide that when the ESOP makes a distribution to an employee owner when he or she retires or leaves the company, the S corporation can take a tax deduction against the UBIT owed for the year in which the distribution is made.

The proposal's effective date is meaningless as it is to apply to all S corporation ESOPs after enactment, and is to lower the tax deduction for distributions made by those companies who did not pay the UBIT between January 1, 1998, and the date when the new law is effective.

Contrast this proposal with current law, which was adopted by Congress, and signed by President Clinton approximately fourteen months before the Administration proposed the drastic change summarized above. Current law provides that the ESOP's share of the S corporation's taxable income is deferred from current taxation until the ESOP makes distributions to the ESOP participants, who are in essence the shareholders of the S corporation.

To understand the Administration's proposal fully requires some history.

Shortly after the enactment of the Tax Reform Act of 1986, the ESOP community urged Congress to enact law to permit S corporations to sponsor employee ownership through ESOPs.

Our efforts gained momentum in 1990 when your colleague Congressman Cass Ballenger introduced the ESOP Promotion Act of 1990, which contained a section to permit ESOPs in S corporations. Similar legislation was introduced in each subsequent Congress, twice attracting over 100 co-sponsors. Each time, eight to ten members of the Ways and Means Committee were original co-sponsors of these pro-employee ownership bills.

In 1996, our advocacy work began to payoff, as the Congress adopted a provision of the Small Business Jobs Protection Act of 1996, a law to permit an S corporations to sponsor an ESOP.

Immediately, however, all realized that the 1996 law was fatally flawed. The major policy problem was the 1996 law was going to tax S corporation income twice if it had an ESOP, because it would have imposed the UBIT on the ESOP's share of the S corporation's taxable income, and a tax on the individuals receiving ESOP distributions.

Groups led by representatives of S corporation groups urged the members of the tax committees to undo the double tax on the ESOP's share of the S corporation's income.

And, at the same time, the ESOP community urged Congress to provide S corporations the same tax benefits for promoting employee ownership as available for C corporations, such as the deferral of the capital gains tax on the proceeds of sales of closely held stock to an ESOP under limited circumstances, deductible dividends paid on ESOP stock in certain circumstances, and the increase in the corporate tax deduction for contributions to an ESOP up to 25% of payroll, plus the interest on the loan used to acquire stock for the employees through an ESOP.

So, as the work on the 1997 law known as the Taxpayer's Relief Act began, these points were being made to Congresspeople supportive of increasing employee ownership in America.

First, in early summer 1997, this Committee adopted by voice vote Congresswoman Johnson's amendment to clean up some of the technical problems with the 1996 law.

Then the Senate Finance Committee had to decide--how to encourage ESOPs in S corporations? Their decision was not to use the C corporation ESOP tax benefits in an S corporation, but to have a unique benefit, the deferral of tax on the ESOP's share of the corporation's taxable income until distributions to the employee owners.

In making this decision, the Senate staff people did review a taxation scheme very similar to the one proposed in the Administration's Fiscal Year 2000 budget. It involved paying the UBIT on the ESOP's share of the S corporation's income, and then later providing a tax credit or tax deduction. But this scheme was rejected. The staff agreed that it was too confusing. They felt that the system would never be clearly understood, or work in the real world.

How ironic that now the Administration makes a similar proposal, which was deemed too complex in 1997!

In any event, the result in 1997 was a decision not to have the C corporation ESOP tax benefits available to an S corporation ESOP but to have the ESOP share of the taxable income of the S corporation subject to a deferred taxation when the beneficial shareholders of the S corporation, the employees got their money from the ESOP.

A key point in all of this decision making is the clear-cut intent of the Senate to have an incentive for the creation and operation of ESOPs in S corporations. In fact, the proposal was scored as a near $400 million revenue drop over the 10 year period of the revenue estimates for the 1997 Taxpayer's Tax Relief Act.

When this approach was proposed by ESOP supporters in the Senate, the ESOP community told key Congressional leaders that this approach was unique, and felt it to be a powerful incentive for the creation of 100% ESOP companies or near 100% ESOP companies operating S corporations.

We were correct. Since the law became effective January 1, 1998, we estimate approximately 75 to 100 of our Association's members have become 100% employee-owned S corporations through an ESOP. Some of these companies increased their employee ownership of their owner's share from less than 100% to 100%.

Clearly in our minds this was the intent--the incentive of the law to increase the distribution of wealth in America.

Is this a good policy? If you support employee ownership, the question becomes is it good employee ownership policy?

Yes, if Congress wishes to have an incentive for 100% or near 100% employee ownership--a level of employee ownership that is rare in America, less than 500 companies, but a level that can be magical in creating an company culture where voices are heard and votes do count--a company like Ewing & Thomas.

Why do large ESOPs, as measured by the size of the company owned by the employees need an incentive that is different from the C corporation ESOPs? Because the 100% ESOP company must have significant cash values as it reaches maturity --5, 10, 15, 20, or more years of employee ownership in order to buy back the stock from departing employees with large accounts in the ESOP. We call this burden on ESOP companies our repurchase obligation, or repurchase liability. Obviously, the bigger share of the company owned by employees through the ESOP, and the older the ESOP becomes, the more money the company has to have to buy back stock from departing employee owners.

All too often we see fine examples of ESOP companies, where employees are sharing substantially in the wealth they help create, abandon employee ownership due to this repurchase obligation issue, and the demands on cash. I cite AVIS and reference Attachment 3.

The one level of tax on a 100% S corporation ESOP solves this problem due to the fact that the cash saved may be used to fund the repurchase of stock from departing employees.

Finally, I cite the objections of The ESOP Association to the Administration's proposal.

Objection One: By being retroactive, by applying to companies like mine that honestly relied on the law passed by Congress, and signed the by the President just fourteen months ago, the proposal pulls the rug out from under the employee owners of my company and others like us.

Those in the Administration who came up with this proposal might think we were naive to believe that the law was for the benefit of companies like ours. Maybe they are laughing behind their backs at us. We may be naive, and not sophisticated to the cleaver nuances of how tax laws are made; but we do know when we are being treated unfairly, and we don't like it.

Objection Two: It is not rational to reverse the 1997 decision to encourage more employee ownership only fourteen months after the decision was made. As representatives of The ESOP Association told key Congressional decisionmakers in 1997, providing a deferral of the tax of the ESOP's share of the S corporation's taxable income would be a significant incentive to be a 100% ESOP company, like Ewing & Thomas believed. The law has worked just as predicted. Why get rid of this incentive?

Objection Three: The Administration's proposal is, in essence, the same, impossible to administer scheme the Congressional staff experts declared incredibly complex in 1997. My non-legal description of the proposal is as follows: The S corporations with an ESOP loans the Federal government money equal to the UBIT tax. Then, 5, 10, 15, 20, or even more years down the road, the Federal government pays back the loan in drips and drabs, in amounts related to distributions of ESOP accounts that will not have any relationship whatsoever to the amount of the UBIT paid in any one year.

Objection Four: The proposal, by permitting a tax deduction for distributions from the ESOP against the current year UBIT owed by the S corporation is an incentive for the corporations to make distributions as rapidly as possible, or timed to profitable years. Thus the proposal is an incentive that is absolutely the opposite of good savings policy, where we want to keep in the money in the savings systems for retirement income security.

Objection Five: The Administration's proposal puts the S corporation with an ESOP at a distinct disadvantage compared to a C corporation ESOP. If the proposal is the law, the S corporation ESOP, particularly those with 100% employee ownership, pays more taxes than C corporations, and have none of the special ESOP tax benefits, such as the ability of certain sellers to an ESOP to deferred the capital gains tax, deductible dividends paid on ESOP stock, and the higher percentage of payroll that can be contributed to a leveraged ESOP. These three are all available to the C corporation, but not the S corporation.

This is a much bigger issue than the tax consequences of S Corporation ESOPs. It is about your stand for employee ownership in America. It is about your belief in increasing the distribution of wealth in this country, about workers having a voice, respect and dignity in the place that they work and security for their retirement years.

The 100% S Corporation ESOP companies are the best this country has to offer--we have done all the right things, for all the right reasons--employee owners!

Members of this committee we ask for your protection from this proposal. We are prepared to work with you and your staff to assure the multitude of S Corporation companies can meet the promise of employee ownership.

I urge you to allow us to work together to spread employee ownership as a commonly accepted way of doing business as we enter the next century.

Thank you for allowing this small company to be heard.

[THE ATTACHMENTS ARE BEING RETAINED IN THE COMMITTEE FILES.]