Many C Corporation companies who sponsor an Employee Stock Ownership Plan elect to pay dividends to their ESOP. This article will provide a summary of the rules that the company needs to follow if they wish claim a deduction on the dividends paid to the ESOP.
IRC Section 404(k)(1) states that, in the case of a C Corporation, there shall be allowed as a deduction for a taxable year the amount of any applicable dividend paid in cash by such corporation with respect to applicable employer securities.
IRC Section 404(k)(2) then explains what is defined as a “Applicable Dividend”. An applicable dividend means a dividend paid for any of the following reasons:
- A dividend which is paid in cash to the participants in the ESOP.
- A dividend which is paid to the ESOP and distributed to participants not later than 90 days after the close of the plan year in which the dividend is paid.
- A dividend which is paid to the ESOP which is, as elected by the participants, either:
- Payable to the participant, or
- Paid to the plan and reinvested in qualifying employer securities
- A dividend which is used to make payments on a loan described in IRC Section 404(a)(9), the proceeds of which were used to acquire the employer securities with respect to the dividend paid.
A C Corporation who pays a dividend to their ESOP for any of the 4 reasons above should be able to claim a tax deduction for those dividends paid. However there are a few additional rules which you need to ensure are followed to allow for the full deduction on those dividends.
If you wish to use dividends (or S Corporation distributions) to make payments on your ESOP loan, keep in mind that you can only use dividends paid on the shares acquired by that loan to make payments on that specific loan. If there was more than one ESOP transaction, as an example, you can’t use dividends paid on Loan 1 shares to make a Loan Payment to Loan 2.
If a C Corporation pays a dividend to their ESOP, and uses dividends paid on allocated shares to make payments on their internal ESOP loan, there is an additional rule which must be followed. This rule is commonly known as the Dividend Make-Whole rule. This make whole rule specifies that if a dividend paid on allocated shares is used to make a loan payment, the value of shares released and allocated from that dividend payment must be worth at least as much as the dividend that was paid.
As an example, if Participant A hold 10 shares of stock in an ESOP, and the company pays a $10 per share dividend, that participant would typically receive a dividend of $100. If the company decides to use that $100 dividend to make an internal ESOP loan payment, the participant must receive at least $100 worth of stock from that loan payment. This make-whole dividend rule also applies for an S Corporation ESOP.
Finally, if a participant makes the election to reinvest their dividends in employer securities, those reinvested dividends must be fully vested for the participant. This may require separate tracking of reinvested dividends from other shares in the ESOP to ensure that these vesting rules are properly applied.
In conclusion if you are paying Dividends or S Corporation Earnings Distributions to your ESOP, it is important that you work with your advisors to ensure you comply with these various rules. Your Blue Ridge administrator will work with you as well to make sure your ESOP follows these rules.