Dividends Versus Distributions In ESOP Planning
This article is an overview of the differences in the utility of C corporation dividends and S corporation distributions in ESOP transactions. It assumes the reader has some familiarity with the basics of ESOPs and the fact that ESOPs may now be sponsored by S corporations. A table comparing the tax attributes of C corporation dividends, which are tax deductible under Code section 404(k), and S corporation distributions can be found in ESOPs – Comparing Cash Flow Conduits, (link, right). This article covers the most important differences for dividends and distributions, including the "reasonable" dividend rule and the potential for unlimited S corporation distributions.
What Is The Difference Between A "Dividend" And A "Distribution"?
For an ESOP (as a shareholder), a "dividend"(C corporation) and a "distribution" (S corporation) are the same thing: a payment of corporate earnings based on share ownership. C corporation dividends are seldom paid by nonpublic companies. S corporation distributions are typically paid to shareholders, usually on a schedule that coincides with payment of annual federal and state taxes by non-ESOP shareholders. Note, however, that "distribution" in the context of an S corporation ESOP has two meanings. Don't confuse S corporation distributions of corporate earnings with a retirement plan distribution (payment from a participant's account) that occurs on a distributable event (e.g., death, disability, or retirement). In this article, S corporation distributions refer to earnings distributions.
There are several fundamental differences in the tax treatment of C corporation dividends and S corporation distributions. A C corporation is an entity subject to "double tax" because income of a C corporation is taxed at the corporate level and potentially again at the shareholder level (at each shareholder's individual tax rate) when, and if, the corporation pays dividends to shareholders. An S corporation is a "pass-through entity," with only one tax on corporate income, which is reported and paid on each shareholder's personal income tax return. For an overview of some of the primary differences between C corporations and S corporations, see "Should Your ESOP Company Elect S Corporation Status?" and "Should Your S Corporation Adopt An ESOP?" (links, right).
C Corporation Dividends
There is a significant exception to the double taxation regime of C corporation earnings for dividends paid to an ESOP. If certain requirements are met, dividends paid to an ESOP may be deducted by the corporation. To be deductible by the corporation, a C corporation dividend must meet one of four requirements below:
- The dividend is paid by the corporation to the ESOP and used to repay an ESOP loan.
- The dividend is paid by the corporation in cash to participants (or beneficiaries) of the ESOP.
- The dividend is paid by the corporation to the ESOP and distributed to participants (or beneficiaries) within 90 days after the close of the plan year.
- Participants are given an opportunity to elect either to (i) receive a dividend in cash from the corporation or (ii) have the dividend paid to the ESOP and reinvested in employer stock. A participant must have a reasonable time to make the election and to change the election at least annually. Any reinvested dividends must be100% vested (regardless of the vesting schedule under the plan or the participant's vested status for plan contributions) or paid only to participants who are 100% vested (partially vested participants would be paid under option 2 or 3, above). Note that this election was not an option prior to January 1, 2002.
Most privately held companies have just one class of common stock. However, unlike their S corporation counterparts, C corporations can have multiple classes of stock, including preferred shares which are owned exclusively by an ESOP. If a corporation with one class of stock declares a dividend, the dividend must be paid to all shareholders. Having a second class of stock in the ESOP is one way a C corporation can prioritize its cash payments. It avoids the need to pay dividends to non-ESOP shareholders. However, preferred stock is subject to some additional limitations. It must be convertible by the ESOP into common stock, and the trustee must retain the right to exercise the conversion in the best interest of the ESOP's participants.
But, before you conclude that preferred stock will allow you to funnel unlimited corporate earnings through an ESOP, read further. If an ESOP is the only shareholder that holds preferred, dividend-paying stock, all dividends are paid to the ESOP on a pre-tax basis. Taken to the extreme, a 100% ESOP owned C corporation could pay significant dividends, and in the past, could reduce its otherwise taxable income to near zero, if prudent, to pay ESOP debt. However, seemingly tax-deductible dividends are potentially subject to alternative minimum tax. The dividends reduce taxable income, but are counted as a tax preference item for alternative minimum tax purposes. The alternative minimum tax rate is 20%. So, otherwise deductible ESOP dividends may actually be subject to a 20% tax rate. The dividend deduction is not totally lost, though. Alternative minimum tax paid results in a tax credit that is carried forward and taken in later years when the corporation is again subject to regular tax, not alternative minimum tax. The company eventually gets the deduction, but it is at a lower present value. Finally, the alternative minimum tax issue may or may not arise, depending on a host of other factors. Read on to learn how dividends on common or preferred stock are now more clearly subject to the reasonable dividend rule.
For an example, see a comparison in the table, "ESOPs – Variations On Dividends And Distributions" (link, right). It illustrates the principles discussed above under the different "C Corp" columns.
S Corporation Distributions
For S corporations, deductibility is not an issue because there is no tax on income at the corporate level. However, there is still a need to reduce taxes paid on corporate income by the S corporation shareholders. An ESOP can help with this. From a lay person's perspective, S corporation distributions can be likened to a tax "credit" to the extent they are paid to an ESOP shareholder. The ESOP is permitted to use these distributions of erstwhile tax dollars for debt service or other ESOP benefit purposes.
Take a look at the example in "ESOPs – Tax 'Credit' For S Corporation Distributions," (link, right). It illustrates the cash flow or "tax credit" perspective of ESOP S corporation distributions. In the example, the S corporation ESOP receives a distribution of $214,500 (money that is not taxed to the corporation or non-ESOP shareholders) which can be used to create a pool of cash to (i) fund repurchase obligations (buying stock from former participants when they terminate employment and their ESOP accounts are paid out), (ii) buy additional shares of stock, or (iii) pay off an ESOP loan. The C corporation pays this as income tax to the federal government.
On the other hand, an S corporation can have only one class of stock, which makes preferred stock unavailable to an S corporation ESOP. Unless an S corporation ESOP owns 100% of the company stock, distributions are paid to non-ESOP shareholders (in proportion to their shareholder ownership of the corporation) so they can pay their taxes. When distributions are paid to non-ESOP shareholders, the ESOP (a shareholder of the company entitled to all the same rights as non-ESOP shareholders) receives its pro rata share. For any company with an ESOP that owns a substantial part of the company's stock, S corporation status can provide substantial tax benefits, potentially reducing federal taxes to zero if the ESOP owns 100% of the shares. For less than 100% ESOP owned S corporations, the cash and tax savings still apply, but the notion of prioritizing cash flow through a preferred stock dividend is not available.
Unlike deductible C corporation dividends, there are no special statutory pass-through rules to allow S corporation distributions to be paid to participants.
The ESOP trustees determine for what purpose it will use the ESOP's distributions. In fact, the S corporation ESOP is not permitted to easily pass through distributions to participants. S corporation ESOPs could distribute these earnings on shares, but only by using the in-service distribution rules that apply to profit sharing and stock bonus plans generally. This means they may be subject to the early distribution penalty tax unless the participant is at least age 59-1/2. If these distributions are paid to a beneficiary after the death of the participant, they would likewise escape the early distribution penalty.
Applying Dividends And Distributions To ESOP Debt Service
The same annual additions limits that apply to other defined contribution plans apply to ESOPs. Annual additions are defined as employer contributions, employee contributions and forfeitures. Dividends and distributions, as earnings on trust assets, are not generally treated as annual additions. If they were, the contribution limit would be reduced by the amount of the dividend or distribution paid to the ESOP, thereby minimizing the use of dividends or distributions to accelerate debt service. However, keep in mind that the Treasury regulations also authorize the IRS in appropriate cases (a facts and circumstances test) to treat certain allocations to participants' accounts (e.g., unreasonable dividends) as annual additions.
Dividends and distributions are typically allocated based on relative account balances, just like other types of earnings. Allocations of earnings based on relative account balances may provide greater benefits for management and long-term employees because their stock account balances (based on higher compensation and longevity) are typically larger than new employees or the rank and file.
The Code allows S corporation ESOPs to use distributions on both allocated and unallocated shares to repay an ESOP loan. Prior to January 1, 2005, only C corporations could use dividends on both allocated and unallocated shares to repay an ESOP loan. S corporation distributions were limited to distributions on unallocated shares. The change in the Code also came with a retroactivity provision. The law applies to distributions paid on shares after January 1, 1998. This raises the following question: Does the law simply provide a reprieve for distributions on allocated shares that were previously improperly used to repay an ESOP loan or is it more than that? Some ESOP commentators conclude that the retroactive effective date is an opportunity to "adjust" prior distributions to apply those distributions previously paid on allocated shares (but not yet used to make payments on a loan) to ESOP loans that are still outstanding.
Both dividends and distributions paid on allocated shares must result in the release of shares to participant accounts in an amount at least equal in value to the dollar amount of the dividend or distribution when paid. Neither dividends nor distributions paid on shares NOT acquired with an ESOP loan can be used to repay an ESOP loan. For a C corporation, they cannot be deducted under the loan payment provision, only under the pass-through provision.
Unlimited S Corporation Distributions?
An important distinction between S corporations and C corporations is that an S corporation can apply virtually unlimited distributions to repay an exempt loan. Whatever an ESOP receives as a distribution on loan-acquired shares can be used to pay off the ESOP loan. Furthermore, if the ESOP owns 100% of the company, then the corporation can distribute what it needs to allow the ESOP to pay its debt, subject to the company's need for working capital, and subject to the rule that the company must make substantial and recurring contributions to the ESOP (not pay just dividends or distributions). Using S corporation distributions can be extremely valuable if additional cash flow is needed beyond the 25% of compensation ESOP contribution limits to finance a transaction. This may be most true, for example, for a company whose stock value is high but whose deductible contributions are limited because of relatively low eligible payroll. Alternatively, perhaps eligible payroll is not low, but the ESOP sponsor wants to accelerate the payoff of an ESOP loan. If the goal of the ESOP is to be a financing tool for a major purchase, or series of purchases, the use of S corporation distributions may grease the skids.
The Reasonable Dividend Rule
In contrast, C corporations are now more clearly limited by the "reasonable dividend" rule. Effective January 1, 2002, the Code was amended to provide that deductions for dividends may be disallowed if the IRS determines that a dividend constitutes, in substance, an "avoidance or evasion of taxation." Prior to this law change, the IRS could disallow a dividend deduction if the IRS determined that the dividend, in substance, constituted an "evasion of taxation" – meaning fraud. An "avoidance" of taxation is easier for the IRS to prove. But what does this mean? An avoidance or evasion of taxation could occur where amounts paid exceed earnings and profits or constitute payment of unreasonable compensation or are not otherwise "reasonable dividends." Unfortunately, there is no clear line in the sand to guide us. According to guidance released by the IRS regarding the deductibility of dividends under the new law, for employers with common stock that is not primarily and regularly traded on an established securities market, the reasonableness of a dividend can be established by comparing the dividend rate on stock held by an ESOP with the dividend rate on common stock of comparable corporations whose stock is primarily and regularly traded on an established securities market. Whether a closely-held corporation is comparable to a public corporation is determined by comparing relevant corporate characteristics such as industry, size, earnings, debt-security structure and dividend history. This new example of reasonableness appears in the committee reports of the 2001 change to the Code, specifically referring to reinvested dividends, not loan repayment dividends. It is not clear, therefore, how much (if at all) the limits to loan repayment dividends have changed since 2001.
It is true that the reasonableness qualifier existed in the legislative history to the Code prior to 2001, but different means have been used, and accepted by the IRS, to establish the reasonableness of the dividend. The IRS will analyze the reasonableness of the dividend using a facts-and-circumstances test, looking at, for example, whether the dividend rate is one that is normally paid in the ordinary course of business and one that the company can expect to pay on a recurring basis. In private letter rulings dating back to the late1980s and in the IRS employee plan examination guidelines, the IRS has allowed dividends that represent a reasonable percentage of the value of the shares on which they are paid, assuming that the corporation could sustain the dividend on a recurring basis. What seems reasonable to you or me, however, may not pass muster with the IRS!
What To Do?
Contact us so we can discuss your objectives. Whether you decide to head down the C pipeline or the S pipeline (or switch midstream) can depend on many transaction design issues. Company size, profitability, value, culture, depth of management and eligible payroll are all factors. For some companies, use of unlimited S corporation distributions may be the only way to adequately meet the ESOP's debt service requirements for a leveraged transaction. On the other hand, potential alternative minimum tax and credit carry forwards and the reasonable dividend rule may or may not be impediments to using C corporation dividends to achieve the most efficient transaction pay-off. The key is weighing and measuring the alternatives.