The Obama Administration’s 2014 budget includes a proposal to eliminate the deduction for dividends paid on employer stock held by an employee stock ownership plan (“ESOP”).  The proposal would be effective for dividends paid after the date the budget is enacted.  Under the proposal, the deduction would continue to be available to corporations with annual receipts of $5 million or less.

Section 404(k) of the Internal Revenue Code generally allows a corporation to deduct dividends paid on its own stock held by an ESOP when the dividends either are passed through to participants or are applied to repay an ESOP loan.  Employer stock funds in 401(k) plans are often designated as ESOPs, and the deduction on ESOP dividends can be worth tens of millions of dollars to sponsors of large plans.

The Administration explained that dividends paid on non-employer stock held by a plan are not deductible and that the “difference in treatment creates an artificial preference for investment in employer stock that is at best difficult to justify.”  The Administration cited concerns that when participants invest retirement savings in employer stock, their retirement benefits are subject “to increased risk (potentially the same risk that could affect their job security) without necessarily offering a commensurate return.”  The Administration observed that the proposal would retain the deduction for companies with annual receipts of $5 million or less because the payment of dividends to participants could have a “productivity incentive effect” in smaller companies.

The Administration estimates that eliminating the 404(k) dividend deduction will raise approximately $400 million in 2014 and almost $10 billion over the next 10 years.