ESOP Dividends: How They Are Handled and Taxed

An Employee Stock Ownership Plan (ESOP) is an employee benefit plan that provides workers with an ownership interest in their company. It functions as a trust, holding company stock for employees. When the company has earnings, it may distribute a portion to shareholders, including the ESOP trust, as dividends. The handling of ESOP dividends is governed by distinct rules, and the company’s structure as a C corporation or an S corporation defines how they are managed and taxed.

ESOP Dividend Handling Options

When a C corporation declares a dividend, the portion for shares held by the ESOP trust presents the plan administrator with several choices, which must be permitted by the plan document.

One option is to “pass through” dividends to plan participants. The company pays the dividends earned on employees’ allocated shares directly to them in cash. This payment is separate from an employee’s regular salary and is treated as an earnings payment.

Alternatively, the plan can retain dividends for reinvestment. The cash is used to purchase additional shares of company stock for the participant’s account, increasing the employee’s long-term ownership stake.

A third option for leveraged ESOPs is to use dividends to repay the ESOP loan. A leveraged ESOP borrowed money to purchase company stock, and using dividends for payments accelerates the release of shares into participant accounts.

Tax Implications for Employees

The tax consequences for an employee are directly tied to which dividend handling option the company chooses. Dividends passed through as a direct cash payment are taxable to the employee as ordinary income in the year it is received. This income is reported on IRS Form 1099-R, not on the more common Form 1099-DIV for regular stock dividends.

A feature of these passed-through dividends is their treatment regarding early withdrawal penalties. Distributions from a qualified retirement plan before age 59½ are subject to a 10% additional tax. However, ESOP dividends paid directly to participants are specifically exempt from this penalty.

When dividends are retained for reinvestment or to repay an ESOP loan, the employee faces no immediate tax liability. The value of these dividends remains within the tax-deferred environment of the retirement plan. The employee does not pay taxes on this amount until they take a distribution from the plan.

The reporting on Form 1099-R is specific; the plan administrator must issue a separate Form 1099-R just for the dividend distribution. This ensures the IRS can distinguish these payments from other plan distributions that might be subject to different tax rules.

Corporate Tax Deductibility

For a C corporation, the treatment of ESOP dividends offers a tax incentive. Unlike regular dividends paid to non-ESOP shareholders, which are paid from after-tax profits, certain ESOP dividends can be deducted from the corporation’s taxable income. This allows the company to make these payments with pre-tax dollars.

A C corporation can claim a tax deduction for dividends paid in cash directly to plan participants or used to make payments on an ESOP loan. This deduction is governed by Internal Revenue Code (IRC) Section 404. The ability to deduct dividends used for loan repayment enhances a company’s capacity to finance the stock purchase on a pre-tax basis.

For dividends passed through to employees, the company can take the deduction in the same tax year that the employees recognize the income. Dividends that are retained for mandatory reinvestment into additional company stock are not tax-deductible for the corporation.

S Corporation ESOP Considerations

The rules for S corporations with an ESOP are fundamentally different from those for C corporations due to their distinct tax structure. S corporations are pass-through entities and do not pay corporate-level income tax. Instead, the company’s profits and losses are passed through to its shareholders, who then report this income on their personal tax returns.

When an ESOP owns part or all of an S corporation, the income passed through to the ESOP’s shares is not subject to federal income tax because the ESOP trust is a tax-exempt entity. This can result in tax savings for the company. Because of this structure, the payments made to shareholders are called “distributions” rather than “dividends.”

These distributions have a different tax character. Since the earnings have already been accounted for at the shareholder level, cash distributions are treated as a non-taxable return of basis. Consequently, when an S corporation ESOP passes these distributions to participants, the payments are not treated as taxable dividends.

An S corporation does not receive a corporate tax deduction for making these distributions to ESOP participants or for using them to repay an ESOP loan. The primary tax advantage for an S corporation ESOP lies in the fact that the share of corporate income attributable to the ESOP is not taxed at the federal level.