Dividends and Employee Ownership
The Power of Dividends
If your employees are owners, should you pay dividends on their shares? 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. Dividends used to repay ESOP loans in a C corporation are tax-deductible and normally do not count towards limits on how much stock can be allocated to employee accounts. Dividends passed through on ESOP shares can also be paid directly to employees, with the company deducting their value. Dividends voluntarily reinvested by employees in company stock in the ESOP are also tax-deductible. If combined with a 401(k) plan, they also can be effectively pre-tax to the employee. 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? Does passing through dividends really provide motivation?
Common or Preferred
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. Dividends paid on ESOP shares, by contrast, are tax-deductible to the company.
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. The trustee must retain the right to exercise the conversion if it is in the best interest of plan participants.
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. Even if this is not a factor, the ability to use dividends to repay a loan is attractive to many public companies for a variety of tax, financial, or accounting reasons.
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. Most people have not ever owned common stock, let alone know what preferred is.
Special Rules for Repaying Loans with Dividends
If a C corporation chooses to use dividends to repay an ESOP loan, several special rules must be considered:
- 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. They can also be passed through to employees.
- Dividends paid on shares not acquired by an ESOP loan (such as shares the ESOP owned before) cannot be used to repay that loan.
- 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. Dividends that are within the range of those paid by other companies with similar earnings clearly would be reasonable, but beyond that, no one knows.
- 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. The application of these rules requires detailed guidance from a specialist.
Employee Tax and Distribution Issues
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. Dividends voluntarily reinvested in company stock are tax-deductible, but if there is a 401(k) plan combined with the ESOP, it is possible to structure the plan so that an offsetting amount of payroll is deducted.
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. Dividends can also be passed through just on vested shares.
Dividends and 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. Bonuses or profit-sharing may work better if short-term incentives are the goal.