Tax-deductible dividends! The powerful, but forgotten incentive for your employees.
What?!
- What if you could grant or bonus stock to your employees and your company could deduct the price of the shares?
- What if you could then declare, pay, and deduct the dividends on just the shares you bonus to employees?
- You wouldn’t have to pay dividends on all the other shares, which of course would not be tax-deductible.
- What if your employees didn’t pay tax on the dividends when you pay them on their stock?
- What if they did not get taxed on the stock grant or the dividends until death, retirement, disability, or six years after they leave the company (or sooner if you want them to have the shares or the dividends)?
- What if they could roll over the shares or the money from selling the stock back to you and the accumulated dividends to an IRA?
Incentive Compensation Based on Corporate Performance
Do I have your attention? Yes, you can actually do all of that. It’s perfectly legal. It’s not some sort of tax dodge. The dividends we are talking about are the only tax‑deductible dividends in the Internal Revenue Code. Congress did this deliberately to promote employee stock ownership.
This means that you provide employees with incentive compensation based on corporate performance. You set the performance criteria any way you want. You pay the dividends out of excess working capital (as if there is any such thing as “excess” working capital). You pay the dividends out of profits, after bonuses, and anything else in your corporate financial planning. Since they are dividends, the payments are not subject to payroll tax withholding.
Why would you do this? Because these days employees are clamoring for incentive compensation. They are clamoring for stock or a piece of the action so that they are an integral part of the company and have a tangible stake in the company’s performance. Independent survey data shows that if employees are presented with identical job opportunities, one with equity compensation and the other with no stock incentive, 60% of the time the employee will take the job offer with the equity incentive. Believe it or not, employees are really motivated these days to help the companies that they are involved in to thrive.
Do you want that too?
This will help improve your management style to give employees a means to make a difference because they are owners of a profit interest in the enterprise. Does having many employee shareholders make you nervous from a management perspective? In this program, employees will never be certificate-holding shareholders. You will not be negotiating buy-sell agreements with them. They will not have the right to attend shareholder or board meetings – unless you want them to see how the company is run and how well-thought-out decisions are made. Research also shows that company stock with a progressive management culture helps companies outperform the competition. Tax-advantaged stock grants with pre-tax dividends are a powerful tool to help your company meet its goals.
Employee Stock Ownership Plans
Okay, so I kept you in suspense. How do you do this? Well, I bet you guessed that my answer is an Employee Stock Ownership Plan or ESOP. It’s not terribly complex or expensive. You can even add it to your 401k/profit-sharing plan without another Form 5500 filing or the cost of another plan audit.
A simple stock bonus ESOP plan can be put in place quickly and cost-effectively. You can contribute as much stock as you want to or you can sell some stock to the plan so the employees own a certain percentage of the business. It’s most common for ESOPs to purchase around 30% of a company when it is set up, but that is not a requirement. Almost any amount of shares will work. Oh, and the cost of the transaction is all financed with tax-deductible dollars.
In addition, if you sell the shares to the ESOP, the seller does not have to pay capital gains tax on the sale. Income taxes on the sale can be deferred – until death if desired. Note: Estate planners plan for this eventuality and ESOP proceeds can be left to heirs without ever paying capital gains tax.
Now, this is only for C corporations, not S corporations. Is that problematic? Not really, when you consider that a lot of companies are open to this strategy, like engineering firms, manufacturing firms, and any company that is mindful of the fact that corporate income tax rates are lower than marginal tax rates for S corporation shareholders.
The fact of the matter is that this has been in the Internal Revenue Code since the 1980s. It is just not used enough. Historically, it was used for highly leveraged ESOP transactions, however, this low-hanging fruit of an employee benefit is often overlooked.
Do I have your attention? Let’s start a conversation.
