The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) expanded
the Code §404(k) dividend deduction for C corporations to apply to dividends
participants elect to have paid to an ESOP and reinvested in qualifying employer
securities. This means that the deduction under §404(k) is available for both
dividends participants elect to reinvest and dividends participants elect to
receive in cash.
In Notice 2002-02, the IRS addresses many questions that have arisen about
the EGTRRA change to §404(k), including effective date, timing of participant
elections, default elections, timing of employer deductions, earnings, contribution
limits, interaction with 401(k) plan hardship rules, vesting, disallowed deductions,
inactive participants, designation as an ESOP and amendment deadlines.
As amended by EGTRRA, §404(k) is effective for taxable years of a corporation
beginning on or after January 1, 2002. Under certain circumstances, if an ESOP
offers participants a choice between reinvestment in employer securities and
distribution with respect to dividends paid by a corporation to an ESOP in 2001,
the corporation may take a deduction for 2002. Also, Notice 2002-02 is generally
effective as of January 1, 2002.
Timing of Participant Elections
The election must be provided in a manner that satisfies the following requirements:
- Participants must be given a reasonable opportunity before a dividend is
paid or distributed to the participants to make the election.
- Participants must have a reasonable opportunity to change a dividend election
at least annually.
- If there is a change in the plan terms governing the way dividends are paid
or distributed, participants must be given a reasonable opportunity to make
an election under the new plan terms before the first dividend subject to
the new plan terms is paid or distributed.
If a participant fails to make an affirmative dividend election, ESOPs may treat
one of the options offered to participants (reinvestment in employer securities
or receipt in cash) as a default election.
Timing of Employer Deductions
Reinvested dividends are deductible in the later of the taxable year in which
(1) the dividends are reinvested in employer securities at the participant’s
election, or (2) the participant’s election becomes irrevocable. Dividends paid
to participants or paid to the ESOP and distributed to participants within 90
days after the end of the plan year are deductible in the taxable year in which
the dividend is paid or distributed to the participant.
Earnings and Losses
Where dividends on employer securities are first paid to an ESOP and then distributed
in cash to participants within 90 days after the close of the plan year, earnings
on those dividends while in the ESOP cannot be deducted under §404(k), even
if the earnings are paid to plan participants at the same time and in the same
manner as the dividends. On the other hand, investment losses attributable to
the dividends reduce the amount of dividend available for reinvestment or distribution
to participants, therefore reducing the amount deductible under §404(k). The
notice also indicates that distribution of amounts not attributable to dividends
from a participant’s account could be treated as violating other Code sections.
The notice’s guidance on earnings and losses applies for deductions taken in
taxable years beginning on or after January 1, 2003.
Dividends that are paid or reinvested pursuant to an ESOP participant’s election
are not annual additions for purposes of the limit on contributions to defined
contribution plans under §415(c), and are not elective contributions under §401(k),
employee contributions under §401(m) or elective deferrals under §402(g).
401(k) Plan Hardship Distributions
Under the 401(k) plan rules, a hardship distribution must be made on account
of an employee’s immediate and heavy financial need, and be necessary to satisfy
the financial need. A distribution is deemed necessary to satisfy an immediate
and heavy financial need if the employee has obtained all distributions currently
available under all the employer’s plans. To satisfy these 401(k) plan hardship
distribution requirements, a 401(k) plan participant seeking a hardship distribution
who also participates in an ESOP that offers a dividend reinvestment election
must elect to receive dividends to the extent currently available under the
ESOP participants must be fully vested in any dividend with respect to which
the participant is offered an election under §404(k). This requirement applies
to applicable dividends under §404(k) for taxable years of a corporation beginning
on or after January 1, 2002. An ESOP can comply with this rule by providing
that participants are fully vested in dividends concerning which an election
is offered, regardless of whether the participant is vested in the stock for
which the dividend is paid. Alternatively, the ESOP can offer the election only
to vested participants.
The Secretary of Treasury may disallow a corporation’s deduction for any dividend
under §404(k) if the Secretary determines that the dividend constitutes tax
avoidance or evasion. This includes the authority to disallow a deduction for
unreasonable dividends. A dividend paid on common stock that is primarily and
regularly traded on an established securities market is presumed to be reasonable.
An ESOP may provide that the same election under §404(k) is offered to all participants,
including both active and inactive participants, and the corporation is allowed
a deduction with respect to all dividends subject to the election.
Designation as an ESOP
In order for an applicable dividend on stock held by an ESOP to be deductible,
the ESOP must be designated as an ESOP no later than the record date for such
dividend and must comply with the other requirements for ESOPs no later than
the record date. The retroactive designation of a plan as an ESOP does not satisfy
the requirement that a plan be designated as an ESOP no later than the record
An ESOP has a remedial amendment period, ending on the last day of the first
plan year beginning on or after January 1, 2005, in which to adopt a retroactive
remedial amendment with regard to amended §404(k). Amendments necessary to establish
an ESOP or for compliance with other ESOP requirements do not have the extended
period. The availability of the extended amendment period is conditioned on
the timely adoption of a good faith plan amendment for amended §404(k), which
means by the end of the plan year in which the first taxable year of the corporation
for which the deduction is being sought ends.