EGTRRA Expands Deductibility For Sponsors Of ESOP Plans

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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.

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.

The language in EGTRRA expands the deductibility to include all dividends paid on ESOP shares for which a pass-through election is offered, regardless of whether or not a participant elects a distribution.

In other words, beginning in 2002 a plan sponsor no longer has to force a distribution of the dividend, but only offer it, to claim the deduction on dividends paid to the plan.

The expanded deductibility can help resolve the longstanding conflict between the finance staffs eagerness to realize the deduction and the benefit staffs reluctance to force participants to receive dividends in cash.

The new EGTRRA ESOP provision is so attractive that it has gained the attention of plan sponsors that do not currently have ESOPs. Many plans are not currently qualified as ESOPs under the provisions of the Internal Revenue Code, but have funds that invest in employer securities.

Faced with the clear financial benefits associated with the pass-through language, many sponsors are examining their plans and considering the steps that would be necessary to convert the stock funds existing within them into ESOPs.

By giving participants a choice as to the reinvestment of the dividends in the new ESOP, they can reap the significant financial benefits associated with such a design while still maintaining the intent of the plan to provide for retirement security.

As with most plan changes, plan sponsors have a number of issues to address when implementing a dividend pass-through in an existing ESOP or converting a portion of an existing plan to an ESOP with a dividend pass-through provision.

For instance, any plan sponsor planning to introduce a pass-through into an existing ESOP should consider:

Whether to permit pass-through of dividends on shares that are not fully vested.

What the schedule for the dividend pay out will be.

When participant elections will be made and how they will be captured.

How the sponsor will communicate the new provision.

How the sponsor will handle additional plan design decisions resulting from converting an existing stock fund into an ESOP.

A sponsor should have all decisions reviewed by legal counsel as well as consultants with expertise in the areas of administration and plan design before completing the plan document and administrative procedures. Plan sponsors that are firmly dedicated to the concept of reinvesting dividends may still choose to forego this valuable opportunity. But, for those that are willing to put the choice in the hands of their participants and address the plan design and administrative challenges, a valuable new option exists.

Rachel Kugelmass is a director in the Fort Lee, N.J., outsourcing division of PricewaterhouseCoopers. Her e-mail address is rachel.kugelmass@unifi.com. Marilyn Scalia is a principal in the outsourcing division. Her e-mail address is marilyn.scalia@unifi.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, October 8, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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