An ESOP is generally funded by two sources, contributions and dividends. Dividends in an S corporation are generally referred to as S corporation distributions of earnings (S distributions). For purposes of this installment, dividends will refer to both dividends and S distributions unless stated otherwise, while S distributions will not include C corporation dividends. Here are some things to consider when determining your dividends, if any, for the year:
- Have you historically paid dividends? If so, what was the amount or percentage and are the employees accustomed to receiving a certain amount or percentage? If you decide to change how you use dividends, you may need to change your communication strategy accordingly.
- Why do you pay dividends? Dividends are often used as a method of funding the ESOP when the maximum deductible contribution has been made and additional funds are still needed to make the required loan payments. S distributions are often paid to non-ESOP shareholders so they can pay their share of federal and state taxes on the company's earnings. If S distributions are paid on non-ESOP shares, they must also be paid on the ESOP shares. C corporations sometimes use pass-through dividends as another benefit for the participants (If so, remember the 2009 Change in Reporting Distributions of 404(k) Dividends on IRS Form 1099-R). A few ESOPs have taken an aggressive position and tried to use deductible redemptive dividends to fund ESOP distributions, running the risk of IRS litigation.
- Are the dividends deductible? The Code provides that C corporation dividends are deductible under Section 404(k) if they are paid to all participants (regardless of their vesting status), used to make loan payments (which will release shares into the participants' accounts), or reinvested in shares (if the participant is given the option to choose between receiving a cash distribution or reinvesting in shares). S corporation distributions are not deductible.
- Are the dividends considered reasonable? C corporation dividends must be reasonable. The IRS determines the reasonableness on a facts and circumstances basis, including factors such as the percentage of total compensation, whether the company can continue to pay the same dividends on a regular basis, and whether the dividends are comparable to dividends paid by similar publicly traded companies in the industry. S corporation distributions are generally not subject to the same "reasonableness" scrutiny.
- Is the fair market value of the shares released by the dividend loan payments at least equal to the dividends used to make the loan payments? If the dividends are being used for loan payments, it is important to ensure that the shares released by the loan payments are worth at least as much as the dividend used to make the loan payment. This is generally only an issue when you have a stock value that is lower than the original cost basis of the shares, but you should perform this analysis annually to ensure that you are compliant.
- Are the dividends used to make loan payments attributable to shares purchased by the loan proceeds? Only dividends paid on shares acquired with the loan proceeds can be used to repay the loan.
- Has the dividend amount been documented in the minutes?
The ESOP Planning process includes planning for both the current year ESOP administration process as well as the various events that take place over the life of an ESOP. This article is one in a series of ESOP Planning 2008 articles authored by Aaron Juckett. Aaron Juckett is an ESOP consultant and the founder of ESOP Insourcing LLC, an ESOP administration and consulting firm dedicated to providing ESOP companies with a first-class ESOP experience. If you need assistance with the ESOP Planning process, please call Aaron at 800-837-3112 or email him at mailto:email@example.com