In my prior blog post, I discussed the maximum contribution deductions limits for an ESOP. ESOPs also have additional tax saving opportunities by providing deductions for dividends paid to an ESOP.
In order for a dividend to be deductible under IRC §404(k), the following requirements must be met:
- The ESOP must be maintained by the corporation paying the dividend or by a controlled group member of the corporation paying the dividend
- The corporation taking the deduction is a C Corporation
- The dividends are paid on employer securities, as defined in IRC §409(l).
In addition, the dividend must be paid in any of the following four ways:
- Paid in cash to the participants in the plan or their beneficiaries
- Paid to the plan and is distributed in cash to participants in the plan or their beneficiaries not later than 90 days after the close of the plan year in which paid
- At the election of such participants or their beneficiaries,
- Paid as provided in option 1 or 2 above, or
- Paid to the plan and reinvested in qualifying employer securities
Fair Market Value Rule
A requirement for deducting dividends paid on allocated shares using option #4 above is the participant must receive employer securities with a fair market value of not less than the amount of the dividend that would have been allocated to the participant in cash. For example, if a participant was allocated $275 in dividends in the ESOP and the dividends were used to make loan payments, the Plan Administrator needs to make sure the shares released from the suspense account have a current value of at least $275. (Under IRC §4975(f)(7), this requirement also applies to S Corporation distributions used to make loan payments, even though the distributions are not deductible to the corporation.)
Timing of Dividend Deduction
Q&A-4 of Notice 2002-2 states when the corporation can take the deduction for options #1-3 above:
(a) Dividends reinvested in employer securities pursuant to an election are deductible in the later of the taxable year of the corporation in which (i) the dividends are reinvested in employer securities at the participant's election or (ii) the participant's election becomes irrevocable.
(b) Dividends paid to participants or paid to the ESOP and distributed to participants within 90 days after the end of the plan year are deductible in the taxable year of the corporation in which the dividend is paid or distributed to the participant.
(c) An election is not considered made until the date the election becomes irrevocable. Therefore, for purposes of (a), dividends are not considered to be reinvested at the participant's election prior to the time that the participant's election becomes irrevocable.
In the case of a dividend deduction under option #4, the deduction is taken in the taxable year of the corporation in which such dividend is used to repay the loan.
Dividends Must be Reasonable
Q&A-11 of Notice 2002-2 addresses when a dividend is excessive and constitutes an avoidance or evasion of taxation:
As amended by § 662 of EGTRRA, § 404(k)(5)(A) provides that the Secretary may disallow a deduction for any dividend under § 404(k)(1) if the Secretary determines that the dividend constitutes, in substance, an avoidance or evasion of taxation. This includes the authority to disallow a deduction for unreasonable dividends.
With respect to dividends reinvested under § 404(k)(2)(A)(iii), a dividend paid on common stock that is primarily and regularly traded on an established securities market (within the meaning of § 54.4975-7(b)(1)(iv) of the Excise Tax Regulations) is presumed to be a reasonable dividend.
In the case of a corporation with no outstanding common stock (determined on a controlled group basis) that is primarily and regularly traded on an established securities market, a determination regarding whether the dividend is reasonable is made by comparing the dividend rate on the stock held by the ESOP with the dividend rate for common stock of comparable corporations whose stock is primarily and regularly traded on an established securities market.
Whether a closely held corporation is comparable to a corporation whose stock is primarily and regularly traded on an established securities market is determined by comparing relevant corporate characteristics such as industry, size of the corporation, earnings, debt-equity structure, and dividend history.