Failure of dividend test

[Guest tmills]

In anything I can find regarding the dividend test not passing, the fix is shown as taking the needed shares from those released by the unallocated share dividend and allocating them with the shares released by the allocated share dividend. The issue here is what if using all shares released by the unallocated share dividend is not enough to pass? In this case it doesn't even work if all the shares released by contributions are allocated as dividend shares. I'm not even sure you can do that.

The dividend is a preferred dividend so the company is looking at it as mandatory and not subject to adjustment. Possible solutions:

1. If shares released by contributions can be used to pass the div test, contribute more.

2. Review the instrument requiring the dividend and see how mandatory it is and the implications of paying a smaller amount.

3. Keep things as is and the company only deducts what it can of the dividend. I'm sure there are other problems with this option.

4. Consult an ESOP attorney and come up with something else. (Of course the attorney should be consulted regardless of the solution.)

Thoughts would be appreciated.

[ESOP Guy]

Your question is a little hard to understand.

Is the problem you are using dividends to pay the ESOP loan and the value of the shares release are worth < the amount of the dividend?

[Guest tmills]

Yes. The problem is the total value of the shares released by loan payments from dividends on allocated (and unallocated) shares does not equal the value of the dividends that the holders of allocated shares would have otherwise received. Therefore a 404(k) problem. Of course a primary cause is a decrease in the share price while the dividend remains fixed.

[ESOP Guy]

In regards to point #3 I really thought there was more at stake than a deduction. I thought if you can’t allocate enough shares by value it can’t be done. I double checked a couple of my client’s ESOP documents. They all say if you can’t meet this test it can’t be done.

It sounds like you have tried the more standard solutions so here is a lead to a possible “out of the box” solution.

Do you have access to the Aspen Publishers ESOP Book? In the 2010 version of the book Q12:21 makes an interesting if vague comment.

It says:

If a deficit exists because of the fair market value rule, the employer will have to contribute additional shares to the plan to make up the deficit…..

It goes on to make a number of qualifiers. But does that make it sound like one could use treasury stock to make up the difference?

You now have heard 100% of what I know about this possible solution. I just remember reading that comment years ago. I tucked it in the back of my brain in case I needed it. I have never followed up on it. I have never had need to try using treasury stock to solve this problem. If anyone else knows about this solution, or if you find out more about this solution I would be interested in knowing.

Not much to go on, sorry, but it might lead down a good path.

[Marcus R Piquet]

I've faced this exact problem a few times this year. And I think you're already on the right track. Here's what I suggest:

1) Check the plan document to see if you can simply forego the deduction. The "FMV rule" here is with respect to the deductibility of dividends, §404(k)(2)(B). If you don't deduct the dividend, does that take care of the problem? As ESOP Guy mentioned, most plan documents I see implement the "FMV rule" no matter whether the sponsor is seeking a deduction or not, so that would be a problem. I wonder if it would be a PT even if you're willing to forego the deduction, but note that the version of the "FMV rule" found in §4975(f)(7) applies only to S corps. No mention there of PT problems for C corps that might forego the dividend. I'd consider this, but only if the plan document allows for it and you've discussed it with an attorney.

2) Review the articles of incorporation. I've found that often the there's no serious consequences for skipping a year. We've had to do this a few times this year for this very reason. As an example, here's a quote from the Articles of one of my clients: "Accumulated, but unpaid, Preferred Dividends, shall cumulate as of the Dividend Payment Date on which they first became payable, but no interest shall accrue on accumulated but unpaid Preferred Dividends. In the event that full cumulative preferred dividends on the Preferred Stock have not been declared and paid, or set apart for payment when due, the corporation shall not declare or pay or set apart for payment any dividends or make any other distribution on, or make any payment on account of purchase, redemption or other retirement of the Common Stock until full cumulative preferred dividends on the Preferred Stock have been paid or declared or set apart for payment; . . . . "

3) This doesn't work as well for C Corps with preferred dividends and may not fit your fact pattern at all, but there is a work-around for §4975(f)(7) for S Corp sponsors that are forced to pay dividends (distributions of earnings) because they can't service the debt within 25% of eligible compensation limit of §404(a)(3). We've had a couple of clients with "inside" ESOP loans do a "write down" of the inside loan. Lender (Company) and borrower (ESOT) agree to reduce the principal balance of the loan to the current FMV of unreleased shares. With the lower principal balance, the loan is easily serviced with employer contributions only. Take a look at PLRs 8612081, 9447057, and 9237037. Very powerful tool for the S corps in light of the current recession.

For the record, I have latent concerns about "stealing" from the shares released as a result of dividends on unallocated shares and allocating them as if they were shares released as a result of dividends on allocated shares. Dividends on allocated shares are allocated on the basis of relative account balances, while dividends on unallocated shares are usually allocated on the basis of eligible compensation. By forcing the allocation in this way, there are winners and losers. Those with lower account balances and/or higher compensation lose, and those with higher account balances and/or lower compensation win. Sounds like a fiduciary decision to me that has some risks. That said, several attorneys have told me they're OK with it so I usually go along with it and hope I don't ever have to explain it to the DOL or IRS.