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The Employee Ownership Update

Corey Rosen

January 7, 2002

(Corey Rosen)

IRS Issues Notice on ESOP Dividends, S Corporation Rule Effective Dates

In Notice 2002-2, the IRS has clarified rules under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) for ESOP dividends and S corporation ESOPs. Effective for plan years starting in 2002 and later, EGTRRA allows companies to deduct dividends paid to ESOP participants that are reinvested in company stock. The notice clarifies several aspects of the dividend reinvestment rules. One clarification of particular note (point 7 below) provides a somewhat more restrictive definition of what a reasonable dividend in an ESOP is and would presumably apply to all ESOP dividends.
  1. Reinvested dividends are not annual additions under Section 415, nor are they considered contributions under Section 401(k) or (m), or elective deferrals under Section 401(g).
  2. Reinvested dividends paid in one year, but reinvested in the next are deductible in the year reinvested. For example, if a company pays a dividend in 2001 to an ESOP, and participants elect to reinvest in 2002, then the dividend is deductible in 2002. In general, reinvested dividends are deductible in the year in which the employee makes an irrevocable election.
  3. Participants must have a reasonable opportunity before the ESOP dividend is paid or distributed to make an election to reinvest. They must also have a reasonable opportunity to change that decision at least annually as well as when the plan terms for dividends change. The plan can provide that a failure to respond to an opportunity to make a change is a default election to continue as before. Elections must be offered not less than 90 days after the end of the plan year in which the dividend was paid.
  4. Investment gains on dividends held in the plan prior to reinvestment are not deductible to the company. Losses on the dividends, or reductions in the dividend amount (such as might follow from withholding requirements of other countries) reduce the amount available to be reinvested and are not deductible under 404(k). This guidance, however, applies only to taxable years in 2003 and later.
  5. Reinvested dividends lose their status of dividends in the ESOP. They are thus are subject to the early distribution tax, but also can be rolled over into an IRA.
  6. Reinvested dividends become fully vested, even if paid on unvested shares.
  7. In public companies, dividends that are paid to ESOP participant shares that are the same as paid on common or preferred stock to other shareholders are considered to be reasonable. In closely held companies, reasonableness is determined by comparing the dividends paid by comparable public companies.
  8. Elections can be offered to terminated participants who still have accounts in the plan.

On the S corporation issue, the IRS clarified that the new S corporation ESOP rules apply to plan years ending after March 14, 2001 if the ESOP is established after that date, or if a C corporation already had an ESOP, but switched to S status after that date. The ruling clarifies that an election to be a S corporation is deemed to be effective as of the date the election first applies. For instance, if a C corporation elects to be an S corporation on March 14, 2001, with the election effective for January 1, 2001, the election is not construed to be in effect on March 14. So the new rules would apply to the first plan year ending after March 14, 2001.

Opposition to IASB Accounting Proposal, IRS Withholding Proposal Grows

The International Employee Stock Option Coalition, a coalition of 26 business groups and 51 companies, has been formed to oppose a proposal from the International Accounting Standards Board (IASB) to require companies to account for the value of options at grant. The group includes most of the major U.S. business organizations and many large companies, especially in the technology sector.

Meanwhile, the Tax Executives Institute has urged the IRS not to impose withholding requirements in disqualifying dispositions of incentive stock options or stock purchased under an employee stock purchase plan.

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