The Congressional Budget Office Recommends Repealing 404(k)
February 26, 2007

The ESOP Association sent out the following message last Friday afternoon:

CONGRESSIONAL BUDGET OFFICE ATTACKS ESOP DIVIDEND DEDUCTION PROVISION—IRC 404(k) The Congressional Budget Office (CBO) has issued its annual report containing 250 recommendations to Congress on how to reduce the Federal Budget Deficit. In language that says there is no proof that ESOPs are effective, the CBO recommends that Congress repeal Code Section 404(k), better known as the ESOP dividend deduction provision that permits C corporations to deduct dividends paid on ESOP stock if passed through to employees in cash, used to pay an ESOP loan, or reinvested by the employee back to the plan for more company stock. [S corporations may use dividends on its ESOP stock to pay ESOP debt, but obviously an S ESOP does not obtain a corporate tax deduction for doing so.] The ESOP dividend deduction provision has been law since 1984.

“Most disturbing is that this staff group of the CBO, which is not a part of the key tax committees of Congress, would go after an ESOP tax benefit as if it were easy road kill,” President Michael Keeling said after reading the CBO recommendations. “But what concerns me even more is the declaration that there is no evidence that ESOPs increase productivity or profitability of companies with ESOPs. The recent University of Pennsylvania research paper by Dr. Stephen Freeman, which is available on our website, demonstrates how incorrect this statement is based on 30 years of research on ESOPs.”

Here is a link to the original language from Budget Options (February 2007):

Option 19 – End the Preferential Treatment of Dividends Paid on Stock Held in Employee Stock Ownership Plans

The report states that “this option would eliminate the tax advantages that are now accorded to ESOPs, effectively rendering them indistinguishable from other qualified retirement plans. That change would increase revenues by $0.4 billion next year and by $3.9 billion over the next five years.”

The report provides the following reasons for eliminating the preferential tax treatment to ESOPs:

1. The current treatment causes similar dividend payments to have different tax consequences for different companies.
2. It hinders the diversification of employees’ retirement portfolios, because the assets of an ESOP, by design, consist primarily of shares of the employer’s stock. If the price of that stock drops, employees may have much less wealth in retirement than they would have had if they had been allowed to diversify their investments, as participants in a typical 401(k) plan can.
3. ESOPs have occasionally been used for purposes for which they were not intended, such as to ward off hostile takeovers by placing large numbers of shares in friendly hands.

As for the reason for keeping the preferential tax treatment, the report states:

“The main rationale for retaining the tax advantages of ESOPs is that having employees own stock directly links their financial interests to their productivity. That is, greater productivity translates into higher profits for the company and thereby increases the value of the employees’ stock. To the extent that the incentive of stock ownership works as intended, ESOPs help promote increased productivity among workers. However, the efficacy of that incentive has not been clearly established.”