Dividend Pass-through

[MoJo]

Has anyone ever researched whether dividends received from a KSOP (through a pass-through provision) are rolloverable? A plan does not allow a participant to not accept passed through dividend once employment has terminated. Every quarter, a check comes, which of course, destroys the benefits of tax deferred compounding. Any insight would be appreciated.

[Guest Jim Schmidt]

I have researched the issue. We pass through dividends on our ESOP. An ESOP dividend is not eligible for roll over if it has been passed through to the participant.

We pass ours through but then allow active participants to offset it with an increased 401(k) deferrral. Terminated employees obviously can't do this so they get the dividend out right, and can't roll it.

[MoJo]

Thanks, Jim. From a sponsor's perspective, what is the benefit of this? The plan I'm thinking about (Marsh & McClennan's - the parent of Mercer (billed as the largest EB consulting firm)) has all monies invested in company stock. Hence, former participants, who are substantial shareholders, have no option to effectively leave funds in the plan....

[Guest Jim Schmidt]

The benefit of the dividend pass through to employees is that your company gets a tax deduction for the dividends they pass through. (Normally dividends paid to shareholders are not tax deductible.) Therefore, every dollar that can be passed through saves the employer $.40 if they are in the 40% tax bracket.

The plan could be designed where terminated participants can leave their dividends in the ESOP, but the Company loses the deduction.

Pretty silly isn't it? There currently is a provision in the 1999 House tax bill that would give the company a deduction even if the employee chose to have their ESOP dividends reinvested. This bill passed the House in July 1999. If this passes, the company can get the deduction without all of this Mickey Mouse manuvering.

[RLL]

The ESOP dividend deduction/reinvestment provision under IRC Sec. 404(k) was included in the Taxpayer Refund and Relief Act of 1999, which was passed by both the House and the Senate early in August. President Clinton has stated that he will veto the tax bill (but not because of this ESOP provision).

The IRS regs under IRC Sec. 402 (1.402©-2, Q & A-4) provide that Sec. 404(k) deductible dividend distributions are not "eligible rollover distributions." Such dividend distributions are also exempt from the Sec. 411(a)(11) consent requirement, the Sec. 3405 witholding requirement and the Sec. 72(t) additional tax on early distributions.

[Guest]

I agree with your recitation of the law, RLL.

But where in the actual statutory language of section 402© does it say that 404(k) dividends are not eligible rollover distributions? Some employers have been eying this issue closely given the negative impact automatic dividend passthrough can have on certain employees.

BTW, this whole dividend passthrough legislation seems to be a complete giveaway of taxpayers' money. I'm surprised Congress didn't just do away with the deduction for ESOP dividends entirely (except perhaps for dividends used to payoff loans) rather than just throw open the doors. What was the retirement policy behind the original legislation granting a deduction for ESOP dividends paid in cash to employees? And what is the tax policy in the new legislation for granting a deduction for dividends that are simply paid into an ESOP?

[RLL]

There is no direct statutory provision that says that a dividend which is distributed to ESOP participants under Sec. 404(k) is not an "eligible rollover distribution" under Sec. 402©. The IRS has taken this position under its regs as being consistent with the concept that the dividend pass-through represents a current payment (of compensation), rather than a payout of deferred compensation for retirement. This position is supportable by reference to the special exemptions for such dividend distributions under Sections 72(t), 411(a)(11) and 3405.

It's interesting to note that the current "pass-through" of dividends to ESOP participants was first recognized by Congress in the Tax Reform Act of 1976 (although legislative history included references earlier) and was specifically included in the IRS regs on ESOPs in 1977. The "pass-through" was made deductible under Sec. 404(k) by the 1984 Tax Reform Act. Congress wanted to encourage the treatment of ESOP participants as beneficial shareholders, who can share in current dividends. It's clear that Congress envisioned ESOPs as more than mere "retirement" plans. The objective was to provide stock ownership interests to employees. It was not until the 1986 Tax Reform Act that the deduction under Sec. 404(k) was extended to dividends used for payments on ESOP loans.

[MWeddell]

The regulation supporting the conclusion that pass-through dividends are not eligible rollover distributions is Treas. Reg. 1.402©-2 (Q&A-4(e)).