DIVIDENDS AND S CORPORATION DISTRIBUTIONS OF EARNINGS

An ESOP is generally funded by two sources, contributions, which were discussed in the previous installment, and dividends.  Dividends in an S corporation are generally referred to as S corporation distributions of earnings (S distributions).  For purposes of this installment, dividends will refer to both dividends and S distributions unless stated otherwise, while S distributions will not include C corporation dividends.  Here are some things to consider when determining your dividends, if any, for the year:

• Have you historically paid dividends?  If so, what was the amount or percentage and are the employees accustomed to receiving a certain amount or percentage?  If you decide to change how you use dividends, you may need to change your communication strategy accordingly.

• Why do you pay dividends?  Dividends are often used as a method of funding the ESOP when the maximum deductible contribution has been made and additional funds are still needed to make the required loan payments.  S distributions are often paid to non-ESOP shareholders so they can pay their share of federal and state taxes on the company’s earnings.  If S distributions are paid on non-ESOP shares, they must also be paid on the ESOP shares.  C corporations sometimes use pass-through dividends as another benefit for the participants.

• Are the dividends deductible?  The Code provides that C corporation dividends are deductible if they are paid to all participants (regardless of their vesting status), used to make loan payments (which will release shares into the participants’ accounts), or reinvested in shares (if the participant is given the option to choose between receiving a cash distribution or reinvesting in shares).  S corporation distributions are not deductible.

• Are the dividends considered reasonable?  C corporations dividends must be reasonable.  The IRS determines the reasonableness on a facts and circumstances basis, including factors such as the percentage of total compensation, whether the company can continue to pay the same dividends on a regular basis, and whether the dividends are comparable to dividends paid by similar publicly traded companies in the industry.  S corporations distributions are not subject to the “reasonableness” test and therefore have no limit as to the amount or percentage.

• Is the fair market value of the shares released by the dividend loan payments at least equal to the dividends used to make the loan payments?  If the dividends are being used for loan payments, than it is important to ensure that the shares released by the loan payments are worth at least as much as the dividend used to make the loan payment.  This is generally only an issue when you have a stock value that is lower than the original cost basis of the shares, but you should perform this analysis annually to ensure that you are compliant.

• Are the dividends used to make loan payments attributable to shares purchased by the loan proceeds?  Only dividends paid on shares acquired with the loan proceeds can be used to repay the loan.

• Has the dividend amount been documented in the minutes?

[CONTRIBUTIONS]

[APPRAISAL OF EMPLOYER SECURITIES]