Dividend Treatment in Employee Stock Option Plans (ESOPs)

Employee Stock Ownership Plans (ESOPs) have gained popularity as a unique and effective way for employees to become partial owners of the company they work for.

However, to make informed decisions and foster a successful employee ownership culture, company leaders must understand and address a number of ESOP complexities. One crucial aspect that company leaders need to comprehend is ESOP dividends-how they are used, and how they are allocated to participants.

For many employee ownership companies, the answer is yes.

Dividends can focus people's attention on ownership and, in ESOPs, can provide unique tax benefits.

If your employees are owners, should you pay dividends on their shares?

Here, Dan Markowitz, CPA, Boulay’s ESOP leader, delves into the key points that company leaders should know about ESOP dividends.

ESOP Dividend Basics

ESOP dividends are paid to the ESOP trust and employee participants receive an allocation of the dividend in their ESOP account.

When the company generates profits and distributes dividends to shareholders, the ESOP trust will receive their portion of the dividend based on their percentage ownership of the Company.

ESOP participants will then receive a share of those dividends based on the number of ESOP shares they own. The dividends allow the employee-owners to benefit directly from the company’s profitability.

This direct connection between company performance and employee compensation can boost morale, productivity, and loyalty.

Employees become more invested in the company’s success, knowing that their efforts directly contribute to the growth of their retirement savings.

An employee stock option gives an employee the right to purchase stock at a predetermined price, regardless of the fair market value of the stock.

Tax Considerations

Company leaders should be aware of the tax incentives related to ESOP dividends.

If the company is a C Corporation, the savings are significant.

Contributions made to the ESOP, including those used to pay for ESOP stock or repay ESOP loans, can be tax-deductible for the company.

Additionally, the dividends received by the ESOP on the company’s shares are tax-deferred, as long as they are reinvested in more company stock, stay in the ESOP trust, or used to service ESOP debt.

This use of pre-tax dollars gives companies the ability to easily obtain and successfully service an ESOP loan, thus making themselves a more attractive borrower to lenders.

Dividends used to repay an ESOP loan are not considered annual additions for Section 415 testing and are also not limited by the maximum contribution amount.

Thus, dividends can provide an additional deduction for the company, beyond those that can be obtained through employer contributions.

One caveat, however, is that dividends on non-leveraged shares cannot be used to make loan payments; so, we recommend consulting with your third-party administrator prior to making the dividend if there are leveraged and non-leveraged shares in the ESOP.

Tax benefits are experienced by the employee-owners, too.

Under the IRS Section 404(k), ESOP participants can receive their dividends in a tax-free manner, provided certain conditions are met.

If employees reinvest their dividends in company stock or roll them over into qualified retirement accounts, they can defer taxes on these dividends until they withdraw the funds during retirement.

This tax advantage can be a significant incentive for employees to participate actively in the ESOP.

Dividends and ESOP Sustainability

When a company pays dividends to ESOP participants, it impacts the company’s cash flow.

Company leaders must balance the desire to reward employees through dividends with the need to maintain the financial health and sustainability of the ESOP and the business itself.

In addition, the payment of a dividend will reduce the company’s excess cash position, which could have a significant impact on the company’s valuation.

Regular communication and collaboration with the ESOP trustee, third-party administrator, and the company’s CPA firm are essential to strike the right balance between growth and dividend distribution.

Accounting for Dividends

Accounting for dividends on a company’s financial statements can be complex and may impact stockholders’ equity, as well as the company’s net income.

Dividends on allocated shares is a reduction of equity and allocated to participants based on share ownership.

Dividends on unallocated shares is usually allocated on compensation, based on the plan definition, and recorded as an expense to the company’s financial statements.

Additionally, understanding how participants are going to participate in the dividend and the impact on repurchase obligation should be considered prior to declaring a dividend.

Additional Considerations

Companies considering paying dividends need to consider several issues in making a decision.

• Should the company use preferred or common stock?
• If dividends are used to repay a loan, what rules need to be followed?

Most privately held companies have just one class of common stock; public companies often have multiple classes.

If a company has just one class, paying dividends on the ESOP shares can require paying dividends on other shares.

Owners of these shares may not want dividends paid to them because both they and the company are taxed on the dividend amount.

To avoid paying dividends to other shareholders, a separate class of dividend paying preferred stock is often created.

If the plan is an ESOP, this generally is convertible into voting common stock.

Preferred stock is a way to pay owners more of their money now, in the form of dividends, and less later, in the form of increased share value.

The higher dividends on preferred stock mean ESOP companies can take full advantage of ESOP rules that allow dividends used to repay an ESOP loan to be deducted.

Because preferred stock pays out more now and less later, it varies less in value than common stock.

This makes it less risky for employees, but it also means employees have less at stake in helping the company to grow long term.

Preferred stock may also be more difficult to communicate.

Dividends on both allocated and unallocated shares can be used to repay a loan.

Dividends paid on allocated shares must release shares to employee accounts at least equal in value to those dividends.

Dividends paid on unallocated shares can be distributed to employee accounts based on the allocation formula for other contributions or on the prior account balance.

Dividends must be "reasonable."

The IRS has not defined what reasonable means, however.

In the one private letter ruling on this issue, a 70% dividend was ruled unreasonable.

Accounting treatment for dividends paid on ESOP loans is complex.

Previous rules indicated dividends used to repay a loan would be charged to retained earnings.

New rules will require them to be charged to compensation expense, with the charge measured by the value of the shares released.

Dividends passed through to employees are taxable and do not qualify for the partial tax exclusion treatment available to non-ESOP dividends.

They are not subject to the 10% early distribution tax, however.

FICA, FUTA, and withholding are not required.

Dividends used to repay a loan end up being allocated as shares and are treated in the same way for tax and distribution purposes.

Plan documents should indicate who decides when and how dividends will be paid.

Participants can be given a choice individually, or the company can make the decision.

Impact on Employee Motivation

Companies that pay dividends often swear by their impact on employee motivation.

The money gives employees an immediate payback from their stock and provides companies with a periodic way to draw employee attention to ownership issues.

In some companies, they may add a few thousand dollars a year in compensation to people who have accumulated a lot of stock.

On the other hand, they provide the greatest reward to those people with the longest participation in the ownership plan.

However, as a short-term reward for good work, they may be ineffective because a new worker making a valuable contribution would get a small fraction of what a more senior employee gets.

Communication and Transparency

Open communication about the ESOP’s financial performance, dividends, and overall impact on employee wealth is crucial.

Transparent communication builds trust and encourages active participation in the ESOP program.

Company leaders should regularly update employees on dividend distributions, the value of their ESOP accounts, and the potential long-term benefits.

ESOP Distribution Payment

An ESOP distribution is the disbursement of a plan participant’s accumulated ESOP benefits due to retirement, termination, death, or disability. *Note: ESOPs are allowed, but not required, to offer hardship distributions.

In those cases, the IRS may waive the 10 percent excise tax if the distribution is taken to cover expenses that qualify as financial hardship, such as medical, funeral, or tuition expenses, and costs paid to avoid foreclosure.

Because it’s subject to ERISA law, an ESOP must meet specific requirements to maintain its tax-qualified status.

Among those requirements are a plan document and a distribution policy.

Requirements for when vested participants receive distributions depend on the reason for their exit.

Internal Revenue Code (IRC) Section 409(o)(1)(B) makes an exception for leveraged ESOPs to defer distribution payments until the close of the plan year during which the loan is paid in full.

If an employee terminates, the company can make the ESOP distribution in shares, cash, or some of both.

Cash is paid to the employee directly.

In other cases, the company distributes the employee’s shares directly to them.

The employee, in turn, then has 60 days to sell the ESOP shares back.

If the employee believes the share value will rise at the company’s next annual valuation, they may opt to wait a year.

Distribution payment can be made either in a lump sum or in “substantially equal” installments over a period of five years.

If the balance is very large (over $1,380,000 in 2024), the five-year installment period can be extended to as long as 10 years.

Certain rules for retirement plans in general can supersede ESOP-specific rules.

For example, plan participants with more than 5% company ownership who are still working at the company on their 73rd birthday are required to begin taking distributions no later than April 1 of the next calendar year.

If the fair market value of the participant’s account balance is less than $500, the ESOP is not required to offer the opportunity to diversify.

The plan document and distribution policy delineates how the ESOP pays out diversification distributions.

While more rare, there are a few ESOPs that offer in-service distributions.

Those that do so must offer in-service distributions equally to all participants.

ESOPs that are C corporations may directly pay participants stock dividends on the shares in their ESOP accounts.

Dividends paid on shares aren’t considered distributions.

In the case of a lump-sum distribution in shares, the plan participant pays ordinary income tax on the value of the company’s contributions to the account.

Plan participants can roll distributions over into a traditional IRA or another qualified retirement plan to defer taxation until the funds are withdrawn according to regulations.

These later withdrawals are taxed as ordinary income.

A participant who rolls over an ESOP distribution to a Roth IRA would pay tax at distribution.

An ESOP’s distribution policy should protect participants and the plan-so it’s vital to give extraordinary care and attention to its development and communication.

ASC 718-40

Employers should report compensation cost equal to the contribution called for in the period under the plan.

The issuance of new shares or the sale of treasury shares to the employee stock ownership plan should be recorded when the issuance or sale occurs, and should report a corresponding charge to unearned ESOP shares, a contra-equity account.

Employers should recognize compensation cost equal to the fair value of the shares for those ESOP shares committed to be released to compensate employees directly.

ASC 718-40 uses the concept of "committed to be released" shares, which are "shares that, although not legally released, will be released by a future scheduled and committed debt service payment and will be allocated to employees for service rendered in the current accounting period."

The legal release of shares generally does not occur until debt payments are made, but employee service to which the shares relate is continuous.

ASC 718-40 notes that the period of service to which the shares relate is generally defined in the ESOP documents.

The shares are deemed to be committed to be released ratably during the accounting period as the employees perform services, and, accordingly, average fair values are used to determine the amount of compensation cost to recognize each reporting period.

For ESOP shares used to settle or fund liabilities for other employee benefits, employers should report satisfaction of the liabilities when the shares are committed to be released.

Compensation cost and liabilities associated with such benefits should be recognized in the same manner as they would if an ESOP had not been used to fund the benefit.

Employers should charge dividends on allocated and committed to be released shares to retained earnings; dividends on unallocated shares should be treated as a payment of debt or accrued interest or as compensation cost, depending on whether the dividends are used for debt service or paid to participants.

For ESOP shares committed to be released that are designated to replace dividends on allocated shares used for debt service, employers should report the satisfaction of the liability to pay dividends when the shares are committed to be released for that purpose.

Employers should credit the contra-equity account “unearned ESOP shares” as the shares are committed to be released, based on the original cost of the shares to the ESOP.

The difference between the amount reported for compensation expense (the fair value of the shares committed to be released) and the amount credited to the contra-equity account (i.e., the cost of the shares to the ESOP) should be charged or credited to shareholders' equity in the same manner as gains and losses on sales of treasury stock (see ASC 505-30-30-5 through ASC 505-30-30-10).

Employers should report redemptions of ESOP shares as purchases of treasury stock.

Employers should report loans from outside lenders to their ESOPs as liabilities on the balance sheet and should report the related interest cost on the debt.

ASC 718-40-40-7 states that the release of remaining suspense shares to participants upon termination of an employee stock ownership plan results in a charge to compensation in accordance with ASC 718-40-25-11 through ASC 718-40-25-14.

However, ASC 718-40 defines "committed to be released shares" as "the shares that, although not legally released, will be released by a future scheduled and committed debt service payment."

This definition implies that shares may be committed to be released prior to the extinguishment of ESOP debt and, therefore, a compensation charge could be recorded prior to the date of the debt extinguishment (i.e., at the time the shares are committed to be released in accordance with ASC 718-40-25-12).

As the definition in ASC 718-40 of "committed to be released shares" addresses situations other than termination of the ESOP, the guidance in ASC 718-40-40-7 should be followed only when accounting for a termination of an ESOP.

Employers typically make cash contributions to employee stock ownership plans, either to fund debt service for a leveraged plan or to purchase shares that will be allocated to participants' accounts in the current fiscal period for a nonleveraged plan.

On occasion, an employer may commit to make additional contributions to the ESOP (either leveraged or nonleveraged) in the future to purchase additional shares of the entity's stock, which will be allocated to the participant accounts of those employees providing service in the year the contributions are made.

This may be the result, for example, of consideration for the plan trustees agreeing to extend the terms of an ESOP loan.

Under ASC 718-40-25-13, compensation expense should only be recognized when the shares are committed to be released to participants, the definition of which includes allocation to employees providing service in the current accounting period, not just the commitment to make a cash payment.

In this case, no expense should be recognized in the current year.

As noted in ASC 718-40-25-3 through ASC 718-40-25-6, if the employer decides to make an additional stock contribution and those shares are unallocated until some future date, the entity should report the share issuance as a reduction of shareholders' equity, as if they were treasury stock with a corresponding charge to unearned employee stock ownership plan shares (contra-equity).

As such, until there is a commitment to release and allocate the shares to participant accounts, no compensation expense should be recorded.

Additionally, the balance sheet should not reflect a liability to the ESOP for a commitment by the employer to contribute additional consideration to the ESOP in the future nor a receivable by the ESOP for the employer’s commitment.

In ESOP accounting, an entity typically eliminates transactions between the employer and the ESOP, and accounts for only external transactions.

This is described in ASC 718-40-25-9(b), which explicitly calls for the elimination of any loans between the employer and the ESOP, as well as ASC 718-40-40-3, which states that, if the employer makes a contribution to the ESOP or pays dividends on unallocated shares that are used by the ESOP to repay the debt, the employer should charge the debt and accrued interest payable only when the ESOP makes the payment to the outside lender.

Helping You Get There

ESOP dividends are a powerful tool for driving employee engagement, fostering a sense of ownership, rewarding employee contributions, and aligning employee interests with company success.

Company leaders must understand the intricacies of ESOP dividends to strike a balance between incentivizing employees and maintaining the company’s long-term financial sustainability.

Through careful planning, open communication, a focus on employee well-being, and the guidance of a trusted ESOP advisor, company leaders can ensure compliance with IRS regulations and make the most of the ESOP’s advantages.

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