3824 / How much may an employer deduct for its contributions to an ESOP?

The deduction rules that apply to profit sharing, stock bonus, and money purchase pension plans ( Q 3750) generally apply to Employee Stock Ownership Plans (“ESOPs”) ( Q 3817) with a few exceptions that expand how much can be deducted. A C corporation with an ESOP is permitted to deduct additional amounts without regard to the deduction limits for profit sharing, stock bonus, and pension plans to the extent such additional amounts do not exceed the IRC Section 415 limits. The rules that follow generally are not available to ESOPs maintained by an S corporation.¹

An employer’s ESOP contributions that are used to repay the principal of a loan incurred to acquire employer securities are deductible up to 25 percent of the compensation paid to covered employees. This deduction limit is measured based on compensation paid in the employer’s tax year for which the deduction is taken. To be deductible, the contribution must have been both paid to the trust and applied by the trust to the repayment of the principal by the due date (including extensions) of the tax return for that year. For contributions exceeding
25 percent of compensation, a contribution carryover is permitted in succeeding years in which the 25 percent limit is not fully used (but contributions to a defined contribution plan in excess of the IRC Section 415 limits may not be carried over).²

In addition, contributions applied by the plan to the repayment of interest on a loan used to acquire employer securities may be deducted without limit in the tax year for which it is contributed if the contribution is paid by the due date (including extensions) for filing the tax return for that year.³

Pass Through Dividends

An employer sponsoring an ESOP also may deduct the amount of any dividend paid on stock held by the ESOP on the record date when the dividend is:

(1)  paid in cash to the plan participants or their beneficiaries;

(2)  paid to the plan and distributed in cash to the participants or their beneficiaries within 90 days after the close of the plan year;

(3)  at the election of the participants or their beneficiaries (x) payable as provided in (1) or (2), or (y) paid to the plan and reinvested in qualifying employer securities (in which case the amounts must be fully vested);⁴ or

(4)  used to make payments on an ESOP loan used to acquire the employer securities with respect to which the dividend is paid.⁵

Dividend payments described in IRC Section 404(k)(2) are not treated as distributions subject to withholding.⁶

---

Planning Point: Dividends on Section 404(k) stock are not subject to the lower income tax rates enacted in 2003 for other types of dividend payments.⁷

---

The IRS has issued guidance on numerous issues related to the election that employers can offer participants or their beneficiaries, as described in (3) above.⁸

The deduction for dividends that a participant elects to reinvest in qualifying employer securities, as described in (3) above, is allowable for the taxable year in which the reinvestment occurs or the election is made, whichever is later.⁹

The IRS may disallow the deduction for a dividend under IRC Section 404(k)(1) if the dividend constitutes, in substance, an avoidance or evasion of taxation.¹⁰

The authority of the IRS to recharacterize excessive dividends paid on ESOP stock as employer contributions was upheld by the Court of Appeals for the Eighth Circuit in a ruling that resulted in disqualification of the ESOP for its resulting failure to meet the IRC Section 415 limits.¹¹