EGTRRA Expands Deductibility For Sponsors Of ESOP Plans
The new Economic Growth and Tax Relief Reconciliation Act could leave some plan sponsors cold.
Although EGTRRA increases the amounts employees can contribute to tax-qualified retirement plans, most provisions have a neutral effect on the sponsors, or actually increase the sponsors costs.
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One exception is a section that applies to sponsors of plans that contain employer securities. This provision, relating to deductibility of dividends paid on shares held in an Employee Stock Ownership Plan, expands an ESOP sponsor’s ability to realize a tax deduction on dividends paid to the ESOP.
Unfortunately, current law poses a dilemma for companies paying ESOP dividends.
Currently, ESOP plan sponsors can recognize a tax deduction on the dividends paid on the shares in the plan if the dividends are either: (i) used to pay debt service on an exempt loan or (ii) allocated to participants in the plan and then immediately distributed from the plan as cash, in a construct referred to as a “pass-through.”
Dividend pass-through can be either mandatory, with dividends paid out automatically to participants, or elective, with participants given the option to either receive the dividends as cash or have them remain invested in the plan.
Under current law, passed-through dividends are deductible only if they are actually distributed in cash within 90 days of the close of the plan year in which they are paid to the plan. The pass-through concept is extremely attractive to finance staff, who often recommend mandatory pass-through, so the employer can recognize the full tax deduction.
Benefits managers tend to argue against pass-through in any form, or agree reluctantly to the elective approach. They argue that requiring payment of dividends to participants is counter to the plan’s stated purpose of providing for retirement savings.
Paying dividends reduces the potential growth of the retirement account and also results in an immediate tax liability for the recipient, benefits managers warn.
This conflict has often led to an unhappy compromise-the implementation of an elective pass-through feature.
Under the elective approach, many participants choose to reinvest their dividends rather than receive them in cash, which results in a total deduction for the plan sponsor that is far smaller than it would have been with a mandatory pass-through.
Other sponsors have risked the ire of plan participants and mandated pass-through of all dividends, thus depriving participants of a valuable opportunity to build their retirement accounts.
Fortunately, the ESOP dividend is addressed by the EGTRRA ESOP dividend provision.