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Employee Benefits Bulletin, April 2002

The Section 404(K) Dividend Deduction did EGTRRA Make Your Company's Plan Eligible? Does Post-Enron Pension Legislation Threaten the Deduction?

Normally, corporations may not take federal income tax deductions for dividends paid to shareholders. However, a special ERISA rule in Internal Revenue Code ("Code") §404(k) permits an income tax deduction for certain dividends paid on employer securities of a C corporation held in an ESOP (retirement plan designed to invest primarily in employer securities). Obviously, this opportunity for substantial tax savings is an incentive for companies to sponsor ESOPs. But, could this rule have significance for your corporation even if it does not have any current plans to establish an ESOP? The answer is yes!

Although ESOPs are normally designed as stand alone plans, they may also be part of a larger stock bonus, profit sharing or 401(k) plan. Employers who are able to label their defined contribution plan, or a portion of the plan (such as the employer stock fund), as an ESOP may become eligible for the §404(k) deduction on certain dividends paid on company stock held in that ESOP. Thus, if your current company 401(k) plan holds employer stock, it could generate tax savings for the corporation after a few amendments are made to the plan.

There is additional good news-the amendments necessary to create an ESOP within your current defined contribution plan have been simplified by the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA"). In a nutshell, under the old law you could take a deduction only if you made a taxable distribution to the plan participants of dividends on employer stock held by the plan; now the same deduction is available without making any distribution or taxing the participant. Put more technically, before EGTRRA, Code § 404(k) allowed a deduction for dividends on stock held in a plan participant's account if the dividend was paid to the participant in cash within 90 days after the close of the plan year in which the dividend was earned. After EGTRRA, a deduction is allowed if the participant can elect to receive the dividend in cash or have it reinvested in employer stock in the plan. This significantly changes the permissible circumstances for taking a deduction. Benefits lawyers showed a very position reaction toward the new law after its enactment. The open observation from a panel of nationally recognized benefits lawyers at the Employee Benefits Committee of the American Bar Association Taxation Section meeting in January- with the IRS present - was that there was absolutely no reason for a publicly traded corporation not to pursue the deduction. This is a strong statement from normally reserved attorneys, and while lawyers are not always sensitive to the problems in administering plan features, the prevailing attitude seems to be that the deduction available under section 404(k) is a no-lose proposition. Still, nothing to do with retirement plans is really "easy," so below are outlined the issues you need to consider (including the potential impact of post-Enron pension reform legislation) in deciding whether it is makes sense to add an ESOP and dividend election to your plans. For many plans the most significant changes would include: (1) ESOP Requirements-participants must be able to receive a distribution of their ESOP account in company stock and be able to diversify their ESOP account into other investments after they reach age 55 and complete 10 years of plan participation; (2) Participant Vesting Requirements-dividends must be 100% vested to be eligible for the election; and, (3) Testing Issues-if the ESOP is part of a 401(k) plan, separate testing of the ESOP and non-ESOP 401(k) portions of the plan would be required.

ESOP Requirements

The deduction is only available to an ESOP. An ESOP is defined in Code §4975(e)(7) as "a defined contribution plan (A) which is a stock bonus plan which is qualified, or a stock bonus and a money purchase plan both of which are qualified under section 401(a) and which are designed to invest primarily in qualifying employer securities; and (B) which is otherwise defined in regulations prescribed by the Secretary." (A stock bonus plan is a defined contribution plan established and maintained by the employer to provide benefits similar to a profit sharing plan except that contributions to the plan are not dependent on profits, and the benefits are distributable in the form of employer stock.)

Other Code sections present additional ESOP requirements. Code § 409(h) requires an ESOP to permit a distribution in the form of employer stock. Section 409(o) requires the plan to permit a participant to elect some investment other than employer stock at age 55 with 10 years of participation (if the accounts are 100% participant directed, as in most 401(k) plans, this diversification rule is satisfied). Finally, §409(e) requires the plan to permit the participant to direct the voting of employer shares in the ESOP.

If these ESOP elements are already present in a plan, amending it to designate the portion of the plan invested in employer stock as an ESOP should be achievable. This is true even if the participants can direct investments out of the employer stock fund.

The Election Requirements

The biggest drawback of the pre-EGTRRA 404(k) provision was that the dividend had to be distributed in cash in order to gain the deduction. This resulted in immediate income to participants. EGTRRA eliminates the need to distribute the dividend, although the participant must be given a reasonable opportunity to elect to receive the dividend in cash or leave it in the plan. If it is left in the plan, it must be reinvested in employer stock. Recent IRS guidance permits an "automatic" or "negative" election. As long as the participant has reasonable notice of the right to make the election, the plan may specify a default treatment of the dividend. So, for instance, if you think most participants would rather leave the dividend in the plan, the plan may specify that the dividend will be reinvested in the absence of an affirmative election otherwise. The election may be made electronically or in any other reasonable fashion.

The actual election is between (A) either (i) the payment of the dividend in cash, or (ii) the payment of the dividend to the ESOP and distribution in cash to participants not later than 90 days after the close of the plan year in which the dividends are paid, or (iii) both (i) and (ii); and (B) the payment of the dividends to the ESOP and reinvestment in employer securities.

An election, once made, can apply for more than one dividend payment, as long as the participant has the opportunity to change his election at least once a year. If you pay dividends more often than annually, you can permit elections for each dividend, or you may permit periodic elections, no less frequently than annual. It is acceptable to make the election an "evergreen" election, so that it stays the same unless the participant makes some change.

Vesting the Dividends

If dividends are available for cash distribution, they must be fully vested. Otherwise, a nonvested participant has a right to receive a dividend in cash even though he might otherwise never actually receive the dividend if he fails to vest under the plan. The dividend vesting rule makes sense if you consider that taking the dividend in cash would vest it anyway. On the other hand, it complicates the administration since you need a separate, 100% vested recordkeeping source to hold the dividends for the nonvested participants. There are several ways to deal with this. One is to offer the dividend election only to vested participants. If you do this, the right to make the election is a plan right that is subject to nondiscrimination testing. Another way is to offer the election to all participants, creating the need for a separate, 100% vested recordkeeping source for dividends paid on nonvested employer contributions. A third way is to offer the election (therefore vesting the dividends) to all active participants and terminated vested participants, but not offer the election (therefore not vesting the dividends) to terminated, nonvested participants. This avoids giving away a dividend to gain a deduction, but there may be other administrative issues that affect this decision. It may very well make the most sense administratively to simply add a "fully vested" dividend "bucket" or "source" for all participants rather than trying to distinguish between vested and nonvested.

401(k) Plan

It is worth mentioning that a 401(k) feature raises one of the more difficult administrative issues in amending a plan to add an ESOP and a 404(k) deduction feature. These issues will be unavoidable for a 401(k) plan. The problem lies with the 401(k) nondiscrimination testing: An ESOP and a non-ESOP cannot be combined for purposes of performing the 401(k) nondiscrimination testing. This means, if the plan is not a safe-harbor 401(k) plan, that the 401(k) deferrals must be kept separate from the ESOP in the year they are contributed to the plan, i.e., the year of the testing. This may constitute the highest administrative hurdle, but it can be solved by adding a separate recordkeeping source to hold 401(k) deferrals for the testing year. At the end of the year, the 401(k) deferrals can be moved into the regular 401(k) deferral source.

The good news as far as 401(k) testing is concerned is that reinvested dividends are not employee deferrals, so they are not included in 401(k) nondiscrimination testing, or in any other testing. This was one of the complicating factors under earlier, pre-EGTRRA analyses.

The Deduction

If the plan offers participants an election, the deduction is available for reinvested dividends in the later of the taxable year in which the dividend is reinvested, or the year in which the participant's election becomes irrevocable. An election is not considered made until it becomes irrevocable. This means, if the record date for a dividend is April 10, 2002, the election period ends April 20, 2002 (thereby making the participant's election irrevocable), and the dividend payment date is May 1, 2002, the deduction is permitted for 2002 (assuming calendar tax years). If you decide to hold the 2002 dividends in the plan until the end of the year and allow the participant to make an election at any time before February 1, 2003, the deduction for reinvested dividends is available for 2003.

The deduction is available for dividends paid or distributed to the participant in the taxable year in which the dividend is paid or distributed.

One complication is how to treat earnings (or losses) if the dividend is not immediately paid out. If a plan holds several dividends until the end of the year, so that it only has one dividend distribution, the earnings on the dividend are not distributable (since they are not the "dividend"), nor are they deductible. The earnings are calculated as of the date the participant's election becomes irrevocable.

If the dividend amount is reduced or suffers investment losses before the dividend is paid, the deduction is reduced to the amount distributed or reinvested.

In recognition of the recordkeeping complexities involved with earnings on dividends, particularly how to trace earnings and dividends if the recordkeeping was not originally set up to do so, the rules regarding earnings are suspended until January 1, 2003. Until that date, presumably you can calculate the deduction in any reasonable manner.

Notice to Participants

You will have to send a notice to participants if you add the ESOP and the corresponding election to reinvest or take stock dividends in cash. The notice can be added to the summary plan descriptions or sent to participants in a separate mailing. Assuming you decide to make the default election an election to reinvest the dividend, the notice would probably change very little from year to year.

Terminated Participants

You are permitted to offer the election to both active and terminated participants. To get the deduction, you must offer the election or pay out the dividend, so it makes sense to offer the election to terminated participants with deferred vested accounts. You may not want to offer it to terminated participants who are not fully vested.

Enron Complications

Although Congress just passed the decidedly favorable section 404(k) rules last year, the recent fallout from the Enron collapse complicates matters. As described in the March Employee Benefits Bulletin and the Legislative Update below, post-Enron pension reform is one of the hottest topics in Washington right now. Lawmakers are considering a range of reform measures, many of which include caps on the percentage of a participant's 401(k) account consisting of employer stock. Obviously, this type of reform measure could impact the effectiveness of ESOP and dividend election amendments. Reform legislation could also affect the 404(k) deduction to a lesser extent by establishing faster diversification rules than those already in place under the ESOP requirements.

Even if the reform legislation does not interfere with the current potential for a 404(k) deduction, Enron is making headlines everyday. Careful communication will be essential in avoiding negative implications to something that should only be a positive for your employees - the opportunity, if they are interested, in taking dividends in cash and, if they are not interested, fully vested dividends for even the newest employees.

For more information on the 404(k) deduction, please contact Frances King Quick. (205) 250-5081.

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