The just-released Obama budget proposal includes a proposal to eliminate the IRC Section 404(k) ESOP dividend deduction for large C corporations (or at least what the Obama administration describes as large for this purpose). The Obama budget proposal would repeal the deduction for dividends paid with respect to stock held by an ESOP sponsored by a C corporation (excluding C corporations with annual receipts of $5 million or less). The current provisions, as described below, allowing for immediate distribution or use of an applicable dividend would remain intact (although without the corresponding deduction). These distribution and use rules would be moved to IRC Section 4975(f)(7), which currently provides rules for distributions relating to S corporation stock held in an ESOP maintained by a S corporation. This proposal, if enacted, would apply to dividends and distributions that are paid after the date of enactment of implementing legislation.
Corporations generally do not receive a corporate income tax deduction for dividends paid to shareholders. As an exception to this general rule, C corporations are allowed a deduction for dividends paid with respect to employer stock held in an ESOP if certain conditions are met. To be eligible for the deduction, the dividend must be an “applicable dividend.” A dividend will be treated as an applicable dividend if the ESOP provides that the dividend is (a) paid directly to plan participants or their beneficiaries, (b) paid to the plan and distributed to participants or their beneficiaries not later than 90 days after the end of the plan year, or (c) at the election of the participants or their beneficiaries, paid directly to the participants or their beneficiaries or paid to the ESOP and distributed in accordance with (a) and (b) above or paid to the plan and reinvested in qualifying employer securities. In addition, a dividend generally qualifies as an applicable dividend if the ESOP provides that it may be used to repay a loan originally used to purchase the stock with respect to which the dividend is paid. For this purpose, the dividend qualifies as an applicable dividend only to the extent that employer securities with a fair market value of not less than the amount of the dividend are allocated to the accounts to which the dividend otherwise would have been allocated.
The budget proposal points out that current law extends several tax benefits to ESOPs that are in addition to those applicable to other tax-qualified retirement plans. The dividend deduction certainly is one of these benefits. Thus, it can be argued that this difference in tax treatment creates an additional incentive for employers to encourage investment in employer stock through ESOPs. As others have done before, the Obama administration here is arguing that concentration of employees’ retirement savings in company stock subjects those savings to increased risk without necessarily offering a commensurate return. Moreover, the administration believes that to the extent current payments of dividends to ESOP participants can spur a productivity incentive effect, the effect may be more likely in small employer settings. Thus, given the way the administration seems to see it, providing an exception from elimination of the ESOP dividend deduction for smaller corporations makes good sense.
It is too early to determine whether this proposal will be enacted. I would point out that this is projected under the Obama budget to raise approximately $6.5 billion over the 2014-23 window. This number, while perhaps not huge in overall budget terms, might be attractive, if Congress, as appears likely, embarks on a mission to find sources of revenue that do not require changes in income tax rates (or that even permit some lowering of those rates). Accordingly, this one is worth watching.