IRS
Explains Recent Changes in ESOP Dividend Deduction Rules
Prepared by: Jeffrey R. Capwell
McGuireWoods LLP
Charlotte, North Carolina
The Economic Growth and Tax Relief Reconciliation Act of 2001 made some changes to the rules governing employee stock option plans (“ESOPs”). One of these changes permits employers to deduct the dividends paid on C corporation stock held in an ESOP if the dividends are either paid to participants in cash or reinvested in that stock, according to participants’ elections. Prior to this change, dividends on ESOP stock were deductible only if paid directly to participants or if paid to the ESOP and then distributed to participants. This provision has generated much interest, particularly among employers who designate the company stock investment funds in their 401(k) plans as part of an ESOP in order to take advantage of the special dividend deduction rule.
In Notice 2002-2, the IRS provides a range of guidance on the new dividend deduction rules. Some of the key points are as follows:
§ The election can be structured in either of two ways. Participants can be offered a choice between payment of the dividends to the ESOP and reinvestment in employer stock, and only one of the following two choices: (1) payment of the dividends in cash directly to them or (2) payment of the dividends to the ESOP and then distribution to them within 90 days following the end of the ESOP’s plan year. Alternatively, participants can be offered a choice between (1) payment of the dividends to the ESOP and reinvestment in employer stock, (2) payment of the dividends in cash directly to them or (3) payment of the dividends to the ESOP and then distribution to them within 90 days following the end of the ESOP’s plan year.
§ The notice clarifies that participants must be given a reasonable opportunity before dividends are paid to make the election and must be able to change their elections at least annually. Plans can designate one of the options as a default election in the absence of an affirmative election from a participant.
§ The election can only be offered if it is permitted under the terms of the plan document. Employers who wish to begin offering the expanded election must amend their plans to reflect the new election. Amendments must be adopted by the last day of the plan year in which ends the first tax year of the employer for which the deduction will be taken.
§ The timing of when the employer can claim a deduction for the dividends paid differs for dividends paid directly to participants or paid to and distributed from the ESOP, versus those that are reinvested. Dividends paid directly or distributed from the ESOP are deductible by the employer in employer’s tax year in which the payment or distribution occurred. Reinvested dividends are deductible in the year in which the later of the following occur: (1) the dividends are reinvested, or (2) the participant’s election becomes irrevocable.
§ The reinvested dividends must be 100% vested at all times.
§ The notice provides special rules for the treatment of investment earnings and losses that occur before a reinvestment election becomes irrevocable, or before dividends are paid or distributed. The earnings on dividends are not deductible. However, investment losses reduce the amount of the dividend therefore reduce the amount of the deduction.
§ If the plan also includes provisions that allow for hardship distributions under the so-called “safe-harbor” hardship standards, then the right to receive dividends in a cash payment must be elected before a participant will be eligible for a hardship distribution. This is because the safe-harbor hardship rules require that the employee have obtained all distributions currently available under all of her employer’s plans.