IRS Passes Along ESOP Dividend Pass-Through Insights

December 19, 2001 ( -The Internal Revenue Service has issued guidelines on companies taking a new tax deduction on dividends passed through to employees holding company stock as part of an Employee Stock Ownership Plan (ESOP).

IRS Notice 2002-2 focuses on tax code changes brought about by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). EGTRRA expanded the existing corporate tax deduction for dividends paid on company stock in an ESOP and passed through to participants.

Dividend Election

The dividend deduction is allowed starting with the tax year beginning January 1, 2002, whether the employee has the dividend reinvested or paid out as a cash distribution ? if the participant is given the choice to have the dividend paid to them in cash, even if they decide to leave the funds invested in the ESOP.

Formerly, the dividends qualified for the special tax treatment only if they were paid to the employee as cash. Under both old and new rules, the dividend must be paid to the participant or their beneficiaries not later than 90 days after the end of the plan year in which the corporation paid the dividends.

Got Questions?

The IRS guidance, issued in question and answer form, among other items, clarifies that:

  • the dividend deduction applies in 2002 if the later of the date on which the dividend is reinvested in employer securities or the date on which the participant’s election becomes irrevocable occurs in 2002, even if the dividend is paid to an ESOP in 2001.
  • a participant must be given a reasonable opportunity before a dividend is paid or distributed to the participant in which to make the election, must have a reasonable opportunity to change a dividend election at least annually, and a reasonable opportunity to change his/her election if there is a change in plan terms regarding how the dividend is paid/distributed.
  • a participant election is not considered made until the date the election becomes irrevocable.
  • earnings on dividends paid under this provision are not deductible under this section
  • the payment or reinvestment of dividends under this provision does not constitute an employee contribution or forfeiture, and are not considered annual additions under § 415(c).
  • reinvested dividends lose their identity as dividends, and are treated as earnings in the same manner as dividends which a participant is not provided an election for
  • a participant wishing to receive a hardship distribution, who is also an ESOP participant, must elect to receive dividends to the extent currently available to the participant under the ESOP
  • the participant is fully vested in the reinvested dividends under this provision

The Internal Revenue Service notes that for further information regarding this notice, plan sponsors can contact Employee Plans’ taxpayer assistance telephone service at 1-877-829-5500 (a toll-free number) between the hours of 8:00 a.m. and 9:30 p.m. Eastern Time, Monday through Friday.

The principal drafters of this notice, Steven Linder of the Tax Exempt and Government Entities Division (TEGE) and John Ricotta of CC:TEGE, may be reached at (202) 283-9888 and (202) 622- 6060, respectively.

IRS Notice 2002-2 is online (or will be soon) at

– Nevin Adams