ESOP dividend pass-through for non-vested employees

[Guest ds86]

In considering a design for an ESOP provision, given the new regulations under EGTRRA, how are pass-through dividends handled for non-vested (less than 100%) employees? Is the entire dividend paid out, regardless of vested percent? Or is the vested amount paid out and the non-vested amount re-invested?

[RLL]

Hi ds86 ---

EGTRRA amended IRC section 404(k) to extend the ESOP dividend deduction to dividends (on employer stock) which are subject to a "pass-through/reinvestment" election by participants....but I don't think that the IRS has yet published new regulations on this provision.

The dividend pass-through/reinvestment election may be available as to all allocated shares or may be limited to vested shares, as determined by the employer per ESOP plan provisions. It's a lot easier to extend the election to all allocated shares....and this will also mean a larger tax deduction for the employer.

The election permits the participant to decide whether to receive dividends in cash or to have the dividends reinvested in employer stock. The employer will be allowed a deduction for dividends on all shares of employer stock with respect to which an election is available to participants.

[Guest ds86]

Thanks for your response. Here's the scenario I'm concerned about. Employee A is 0% vested (assume 5-year cliff) and elects to take a pass-through. Employee B is also 0% vested but elects to have the dividend re-invested.

Both employees terminate before becoming 100% vested. Employee A has received a payment from the plan while Employee B forfeits the re-invested dividend.

If I limit the option to only 100% vested employees, I will likely fail to meet non-discrimination requirements. If the dividends are paid out, I risk losing money that could be forfeited back to the company.

Am I right in these scenarios? I'm assuming this situation has always existed for plans with pass-through dividends, but I haven't heard of anyone else dealing with the vesting issue.

[RLL]

ds86 ---

Forfeitures are usually reallocated to other participants. Forfeitures may not revert to the company, although they may be applied to reduce future company contributions.

The fact that one non-vested participant elects cash and another elects reinvestment should not be a major concern if that's what the ESOP provides for. If one terminates and forfeits, he/she may wish that he/she had elected to receive cash...but he/she made the choice.

It's easier administratively to allow the election on all allocated shares, and the company's tax deduction for dividends will be larger. This may outweigh the "benefit" of using future forfeited reinvested dividends to reduce the company's future contributions.

[Guest carsca]

RLL,

Your approach begs the question as to whether a Company would be ALLOWED to limit dividend pass-through to only vested participants under the new law.

I believe that under the old "switch back" arrangements there would be no discrimination issue in the event that the Company decides not to offer dividend pass-through to participants who are less than 100% vested. The reason is that IRC 404(k) is not subject to IRC 401(a)(4).

Based on my preliminary reading of the Act, I would think that a Company should similarly be able to limit dividend pass-through to only vested participants and still get a deduction for the vested participants who were offered dividend pass through.

Agree?

[RLL]

Hi carsca ---

I agree with you that section 404(k) would allow it....but I did not "beg the question," as this quote from my first post indicates:

"The dividend pass-through/reinvestment election may be available as to all allocated shares or may be limited to vested shares, as determined by the employer per ESOP plan provisions."

The dividend election is not subject to IRC section 401(a)(4) by reason of section 404(k)(5)(B).

[Guest carsca]

My bad, RLL, I did not see (or properly take note of) your earlier post.

Thanks for the confirmation!