Last week we discussed the news that the House Draft of Tax Reform Legislation did not have a direct impact on ESOPs. While this is definitely positive news for ESOPs, President Obama's Budget for Fiscal Year 2015 has been released and it includes language to eliminate the IRS Section 404(k) ESOP dividend deduction for publicly traded C Corporations. IRC Section 404(k) is the section in the Internal Revenue Code that provides the C Corporation provisions for paying Deductible Dividends to an ESOP:
ELIMINATE DEDUCTION FOR DIVIDENDS ON STOCK OF PUBLICLY-TRADED CORPORATIONS HELD IN EMPLOYEE STOCK OWNERSHIP PLANS
Generally, corporations do not receive an income tax deduction for dividends paid to their shareholders. However, a deduction for dividends paid with respect to employer stock held in an employee stock ownership plan (ESOP) is allowed if certain conditions are met. The deduction is available even if the ESOP is merely an “ESOP account” that is one of the investment options available to employees under a section 401(k) plan (which holds salary reduction contributions elected by employees and, often, contributions that match those elective contributions). In addition, the special deduction is available regardless of the extent of the ESOP’s ownership interest in the corporation.
To be deductible, the dividend paid must be an “applicable dividend.” A dividend qualifies as an applicable dividend only if the dividend is paid or used in accordance with one of four available alternatives. Specifically, a dividend qualifies as an applicable dividend if the dividend is (i) paid directly to the plan’s participants or their beneficiaries, (ii) paid to the plan and distributed to participants or their beneficiaries not later than 90 days after the end of the plan year, or (iii) at the election of the participants or their beneficiaries, could be paid either as described in (i) or (ii). Additionally, a dividend qualifies as an applicable dividend if it is used to repay a loan originally used to purchase the stock with respect to which the dividend is paid. For this purpose, the dividend qualifies as an applicable dividend only to the extent that employer securities with a fair market value of not less than the amount of the dividend are allocated to the accounts to which the dividend would have been allocated. The limitation on deductibility of dividends used to repay loans to those paid with respect to stock acquired with those loans does not apply to employer securities acquired by an ESOP prior to August 4, 1989 (if the plan was an ESOP prior to that date).
A deduction for a dividend that otherwise qualifies as an applicable dividend may be disallowed if the Secretary determines that the dividend is, in substance, an “avoidance or evasion” of taxation. This includes authority to disallow a deduction of unreasonable dividends, which has been used to recharacterize excess dividends as contributions subject to the limit on annual additions under section 415. Thus, the authority to disallow a deduction for a dividend serves not only to disallow the deduction but also to constrain any dividend that, in substance, constitutes an employer contribution to the ESOP in excess of the otherwise applicable limit on annual additions.
When distributed to participants or their beneficiaries, either directly or from the plan, applicable dividends constitute taxable plan distributions (ordinary income) but are not subject to the 10-percent early distribution tax. Applicable dividends are not treated as wages for purposes of income tax withholding or federal employment taxes.
Reasons for Change
Current law extends several tax benefits to ESOPs that are in addition to those applicable to other tax-qualified retirement plans. The ESOP dividend deduction is one of these benefits. Thus, while current law generally does not allow a paying corporation a deduction for dividends paid with respect to its stock, including stock that is held in a retirement plan, the deduction for dividends on employer stock held in an ESOP is an exception to this rule. The difference in treatment creates an additional incentive for employers to encourage investment in employer stock through ESOPs. However, concentration of employees’ retirement savings in the stock of the employees’ employer entails a risk that poor corporate performance or other factors will lead to a loss in value of the stock and hence of employees’ retirement savings (which is the same risk that could also affect their job security) without necessarily offering a commensurate return. Providing special tax benefits for ESOPs, including the tax deduction for current payments of dividends to ESOP participants, has been justified as encouraging employee ownership, which in turn has been viewed as having a productivity incentive effect, but this effect is more likely for employers that have a significant degree of employee ownership, where there may be a greater possibility that the benefits of any such incentives could justify the risks associated with the concentration of retirement savings in employer stock. Ownership of stock of a publicly traded corporation through an ESOP seems unlikely to offer significant productivity incentives to employees because their aggregate ownership interests in the corporation are more likely to be small relative to the ownership interests of public shareholders. Instead, in the context of publicly held corporations, the special dividend deduction for stock held in ESOPs has frequently served to encourage 401(k) plan sponsors to amend an existing employer stock fund investment option in a 401(k) plan to constitute an ESOP in order to benefit from the dividend deduction without significant changes in the character of the account or the extent of employee ownership. By eliminating the ESOP dividend deduction for dividends on employer stock of a publicly traded corporation held in an ESOP, the proposal seeks to strike a balance between the competing policy considerations.
The proposal would repeal the deduction for dividends paid with respect to employer stock held by an ESOP that is sponsored by a publicly traded corporation. Rules allowing for immediate payment of an applicable dividend would continue as would rules permitting the use of an applicable dividend to repay a loan used to purchase the stock of the publicly traded corporation. The Secretary would continue to have authority to disallow an unreasonable dividend or distribution (as described in section 1368(a)) for this purpose.
The proposal would apply to dividends and distributions that are paid after the date of enactment.
The ESOP Association expressed disappointment over the budget provision.
“Obviously, we are disappointed this provision has been included in the President’s budget,” said ESOP Association President, J. Michael Keeling. “We are baffled by the Administration. How can the Administration preach about creating jobs and then plan to take away a proven policy that sustains jobs? Furthermore, the provision the Administration wants to kill was added in 1984 by Congress to address income inequality by encouraging employee owners to have more income from ownership. It is counter-intuitive. As we’ve said before, research proves that ESOPs, and companies with other forms of employee stock ownership, provide more sustainable employment. The Administration needs to step up and encourage broad-based inclusive capitalism and increase employee ownership to ensure sustainable employment for U.S. workers, and more income for average pay employee owners, not decrease support.”
UPDATE: The March 14, 2014 NCEO Employee Ownership Update highlights that the 2014 Greenbook cut the dividend for all companies over $5M in revenue whereas the 2015 Greenbook does so for all public companies.
President Obama's proposed 2015 budget includes some provisions that would affect ESOP companies. Most notably, the General Explanations of the Administration's Fiscal Year 2015 Revenue Proposals (the so-called "Green Book") says the "the proposal would repeal the deduction for dividends paid with respect to employer stock held by an ESOP that is sponsored by a publicly traded corporation." This is a change from the President's 2014 budget proposal, which called for eliminating the deduction for all C corporations with $5 million or more in revenue.
However, there is some positive news. The 2015 Greenbook modified the language compared to the 2014 language and it provides a more favorable and nuanced perspective than the 2014 Greenbook Explanation on Eliminating ESOP Dividend Deduction which painted ESOPs negatively with a very broad brush:
“Concentration of employees’ retirement savings in the stock of the company for which they work, however, subjects employees’ retirement benefits to increased risk (potentially the same risk that could affect their job security) without necessarily offering a commensurate return.”
ESOP Association President, J. Michael Keeling, provided his perspective on this change in verbiage and noted that it is rare for an administration to make a proposal one year and not just copy it verbatim the next year.