Section 404 of the Internal Revenue Code provides for the deductibility of cash dividends paid to an ESOP, provided that the dividends are passed through in cash to plan participants within 90 days of the end of the tax year. In the alternative, the dividends may be paid directly to the participants without first being paid to the plan.

The purpose of the dividend pass-through provision is to provide greater employee incentives by enabling the participants to realize current income from the plan. In many cases, the payment of a cash dividend has had a dramatic effect on employee motivation and incentive.

The dividend deduction applies to either common stock dividends or to dividends on convertible preferred stock.

Participants are fully taxable on these payments, and are not eligible for the $100 exclusion of dividend income. The dividend is deductible to the corporation in the taxable year in which the dividend is distributed to the participants. The dividend is deductible, however, only with respect to shares that have been allocated to the plan participants.

Section 404 of the Code also provides for the deductibility of dividends used to make payments on an ESOP loan. The deduction is allowed in the taxable year of the corporation in which the dividend is used to make loan payments. The dividend is deductible, however, only on the stock that is purchased with the loan proceeds.

This provision is particularly useful in cases where a contribution of 25% of eligible payroll (the maximum allowed under 404(a)(9) of the Code) is not sufficient to repay the annual principal payment to the lender. In such cases, the solution may be to pay a deductible dividend, and use the dividend to make up the difference between the contribution amount and the required principal payment. The dividend must, however, be "reasonable."

One disadvantage of both types of dividend payments is that a dividend must be paid to all holders of the same class of stock. Thus, if the founder still holds 70% of the outstanding stock, only the portion of the dividend that is paid to ESOP will be deductible. The solution to this problem is to have all the shareholders, other than the ESOP, waive the dividend prior to the date that the dividend is declared. Similarly, if the ESOP holds stock that was not purchased with the proceeds of a loan, only the dividends paid on the ESOP stock bought with loan proceeds will be deductible. A solution to this problem is to recapitalize the corporation so that the ESOP purchases a separate class of dividend paying stock.

Regulation section 1.56(g)-1(d)(3)(iii)(E) provides that deductible dividends must be added back to the calculation of adjusted current earnings for the purposes of calculating Alternative Minimum Taxable Income. Thus, to the extent that the company becomes liable for the Alternative Minimum Tax, the company will not enjoy the full tax benefit of deducting the dividend payments.

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