Using dividends to make ESOP loan payments

[Guest Becky Hoffman]

The company is a C corporation. The ESOP purchased stock in 1994 with the proceeds of a loan. The ESOP again purchased stock in 1998 with the proceeds of a loan. The ESOP used dividends paid on the 1994 stock to make payments on the 1998 loan. Obviously the dividend is not deductible. However I also believe that the use of such dividend would be a prohibited transaction. But I am getting mixed answers.

The exemption for ESOP loans under 54.4975-7(B)(5) does not allow dividends paid on company stock other than dividends paid on the collateral stock for such loan to be used for debt payments. IRC 404(k) expands acceptable sources of repayment without violating the prohibited transaction exemption to dividends paid on allocated shares purchased with the proceeds of the loan being paid if other requirements are met. Therefore, does the use of such dividends cause a prohibited transaction? If so, what should be done to correct the problem?

[QDROphile]

No prohibited transaction. The regulation you cite only applies to what the lender may have by way of a security interest. In effect, the lender may have an interest in the suspense account (the unallocated stock plus dividends on the unallocated stock). The regulation has nothing to do with use of dividends to pay the loan except to limit the dividends that are subject to the security interest.

[Guest Harry O]

I agree with Becky . . .

Section 54.4975-7(B)(3) provides that no loan will satisfy the requirement that such loan be primarily for the benefit of ESOP participants and beneficiaries, unless it satisfies paragraph (B)(4), (5) and (6). Section 54.4975-7(B)(5) provides, in relevant part, [*4] that payments made with respect to an exempt loan by the ESOP during a plan year must not exceed an amount equal to the sum of contributions made to meet loan obligations, earnings from the investment of such contributions and earnings attributable to collateral given for the loan. The only assets of the ESOP which may be given as collateral on an exempt loan are qualifying employer securities of two classes: those acquired with the proceeds of the loan and those that were used as collateral on a prior exempt loan repaid with the proceeds of the loan.

Thus, the only earnings upon employer securities which may be used to repay an exempt loan are those earnings attributable to the unallocated securities held as collateral (or allocated securities held as collateral as provided under the TAMARA amendments to section 404(k)). Look at PLR 8921101.

In any event, this is too big an issue to not get help on. Contact a good benefits lawyer!

[Guest Larry Goldberg]

Becky: Harry O is right on target. However, let me emphasize that 54.4975-7(B)(5), after limiting the ESOP assets a lender can recover to "earnings attributable to such collateral", states that payments on the loan cannot exceed ". . . an amount equal to the sum of such contributions and earnings. . ." The reference to "such earnings" refers back to the statement limiting recourse to earnings attributasble to such collateral.

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[Dawn Hafner]

The IRS ESOP Examination Guidelines do not seem to interpret 54.4975-7(B)(5) to limit the actual repayment sources that the plan used, but rather what a lender can seek in repayment of the loan. See Sub-Section 434.

Also, in Sub-Section 426.2 there is a paragraph that discusses looking at if any dividends used to repay an exempt loan were not generated by securities acquired in that exempt loan. If the answer is "yes" the guidelines state to disallow the deduction, but they don't mention any action relating to a prohibited transaction.

Anyone have any previous audit situations where this was an issue brought up by the agent? If they use their guidlines, it doesn't appear they would view this as a PT under exam. I do see how that paragraph of the regulation can be read either way though.

[Guest Becky Hoffman]

Dawn Hafner and QDROphile...

If using such dividends would not be a prohibited transaction, would you say that using contributions made before the loan was established or earnings on other investments in the plan purchased prior to the loan would be a prohibited transaction?

[QDROphile]

I apologize for not paying adequate attention to either the question or my answer. I agree that the regulations prevent aggregate loan payments on the 1998 loan for the year from exceeding aggregate contributions plus aggregate dividends on the stock aquired with the 1998 loan proceeds, whether or not those shares have been allocated. Although we could talk about how to move sources and uses around, this effectively means that you can't pay off more of the loan with dividends on other shares. If your contributions plus dividends on 1998 shares for a year are $20,000, you can't pay more than $20,000 of 1998 loan debt service in that year. I assume we are not contemplating sale of any suspense account shares, which brings in other concerns.