There are times when the amount of loan payments that a company would like to pay on its ESOP loan are greater than the Internal Revenue Code Section 404 deduction limits. One strategy is to see if you are able to deduct 50% under IRC Section 404. Another strategy is to use dividends.
404(k) Deduction Rules
If you are a C Corporation, a dividend is deductible under IRC Section 404(k) - Deduction for dividends paid on certain employer securities if the dividend:
"(i) is paid in cash to the participants in the plan or their beneficiaries,
"(ii) is 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,
"(iii) is, at the election of such participants or their beneficiaries—
(I) payable as provided in clause (i) or (ii), or
(II) paid to the plan and reinvested in qualifying employer securities, or
"(iv) is used to make payments on a loan described in IRC Section 404(a)(9)(A) - Certain contributions to employee stock ownership plans the proceeds of which were used to acquire the employer securities (whether or not allocated to participants) with respect to which the dividend is paid. "
Dividends Must be Reasonable
Of course, there are limits to the amount of dividends that you can pay. To be deductible, IRC Section 404(k)(5)((A) provides that dividends must be reasonable and not constitute an avoidance or evasion of taxation. Unfortunately, the IRS has not defined the meaning of reasonable. Instead, 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.
IRS Examination Steps
Internal Revenue Manual (IRM) 4.72.4, Employee Plans Technical Guidance, Employee Stock Ownership Plans (ESOPs) provides the following 404(k) deduction examination steps:
Cancelled checks, payroll records, trust receipts and disbursement records, and participant's accounts should be examined to determine that the IRC 404 limits have not been violated. Problems could also arise if the number of participants decreased so as to lower the deductible limits.
Look at the applicable question on Schedule E, ESOP Annual Information, of Form 5500, to find out whether the employer repaid the exempt loan using dividends on employer securities.
Look at the question on Schedule E with regard to whether any dividends used to repay an exempt loan were not generated by employer securities acquired in that exempt loan. If the answer is yes, find out if the employer securities paying those dividends were acquired after 8/4/89. If yes, disallow the deduction.
Determine whether the amount of dividends paid exceed the employer's current or accumulated earnings or profits under IRC 316. Review the question on Schedule E of Form 5500 for this information. If yes, disallow the deduction. [Here is a link to IRC Section 316 – Dividends defined]
Check whether the dividends paid on employer securities held by the ESOP are reasonable. A reasonable dividend does not include an unusually large dividend used to repay ESOP debt which is greatly in excess of the dividend the ESOP sponsor can reasonably be expected to pay on a recurring basis.
Determine whether any corporate redemptions of ESOP stock were deducted under IRC 404(k). If yes, disallow the deduction.