Understanding ESOP Dividends: A Guide for ESOP Company Leaders

Employee Stock Ownership Plans (ESOPs) have gained popularity as a unique and effective way for employees to become partial owners of the company they work for. However, to make informed decisions and foster a successful employee ownership culture, company leaders must understand and address a number of ESOP complexities.

One crucial aspect that company leaders need to comprehend is ESOP dividends—how they are used, and how they are allocated to participants. In this article, Dan Markowitz, CPA, Boulay’s ESOP leader, delves into the key points that company leaders should know about ESOP dividends.

ESOP Dividend Basics

ESOP dividends are paid to the ESOP trust and employee participants receive an allocation of the dividend in their ESOP account. The dividends allow the employee-owners to benefit directly from the company’s profitability. When the company generates profits and distributes dividends to shareholders, the ESOP trust will receive their portion of the dividend based on their percentage ownership of the Company. ESOP participants will then receive a share of those dividends based on the number of ESOP shares they own. This direct connection between company performance and employee compensation can boost morale, productivity, and loyalty. Employees become more invested in the company’s success, knowing that their efforts directly contribute to the growth of their retirement savings.

Tax Considerations

Company leaders should be aware of the tax incentives related to ESOP dividends. If the company is a C Corporation, the savings are significant. Contributions made to the ESOP, including those used to pay for ESOP stock or repay ESOP loans, can be tax-deductible for the company. Additionally, the dividends received by the ESOP on the company’s shares are tax-deferred, as long as they are reinvested in more company stock, stay in the ESOP trust, or used to service ESOP debt. This use of pre-tax dollars gives companies the ability to easily obtain and successfully service an ESOP loan, thus making themselves a more attractive borrower to lenders.

Dividends used to repay an ESOP loan are not considered annual additions for Section 415 testing and are also not limited by the maximum contribution amount. Thus, dividends can provide an additional deduction for the company, beyond those that can be obtained through employer contributions. One caveat, however, is that dividends on non-leveraged shares cannot be used to make loan payments; so, we recommend consulting with your third-party administrator prior to making the dividend if there are leveraged and non-leveraged shares in the ESOP.

Tax benefits are experienced by the employee-owners, too. Under the IRS Section 404(k), ESOP participants can receive their dividends in a tax-free manner, provided certain conditions are met. If employees reinvest their dividends in company stock or roll them over into qualified retirement accounts, they can defer taxes on these dividends until they withdraw the funds during retirement. This tax advantage can be a significant incentive for employees to participate actively in the ESOP.

Dividends and ESOP Sustainability

When a company pays dividends to ESOP participants, it impacts the company’s cash flow. Company leaders must balance the desire to reward employees through dividends with the need to maintain the financial health and sustainability of the ESOP and the business itself. In addition, the payment of a dividend will reduce the company’s excess cash position, which could have a significant impact on the company’s valuation. Regular communication and collaboration with the ESOP trustee, third-party administrator, and the company’s CPA firm are essential to strike the right balance between growth and dividend distribution.

Accounting for Dividends

Accounting for dividends on a company’s financial statements can be complex and may impact stockholders’ equity, as well as the company’s net income. Dividends on allocated shares is a reduction of equity and allocated to participants based on share ownership. Dividends on unallocated shares is usually allocated on compensation, based on the plan definition, and recorded as an expense to the company’s financial statements. Additionally, understanding how participants are going to participate in the dividend and the impact on repurchase obligation should be considered prior to declaring a dividend. 

Transparency and Communication

Open communication about the ESOP’s financial performance, dividends, and overall impact on employee wealth is crucial. Transparent communication builds trust and encourages active participation in the ESOP program. Company leaders should regularly update employees on dividend distributions, the value of their ESOP accounts, and the potential long-term benefits

Helping You Get There…

ESOP dividends are a powerful tool for driving employee engagement, fostering a sense of ownership, rewarding employee contributions, and aligning employee interests with company success. Company leaders must understand the intricacies of ESOP dividends to strike a balance between incentivizing employees and maintaining the company’s long-term financial sustainability. Through careful planning, open communication, a focus on employee well-being, and the guidance of a trusted ESOP advisor, company leaders can ensure compliance with IRS regulations and make the most of the ESOP’s advantages.

Boulay’s ESOP advisory team is dedicated to helping you get there with expert advice throughout the ESOP life cycle. To learn more, connect with us today.