S Corp sponsors an ESOP that owns more than 50% but less than 100% of the Company. The company has some non-employee shareholders and must (or has decided to) pay dividends so that the shareholders will have cash to pay taxes.

The Company wants to amend the ESOP allocation formula so that the amount of contributions allocated to a participant's account is reduced by the amount dividends allocated to the account. For example, each participant would receive 5% of compensation minus the dividends (but not below zero). The end result is that each active participant's account receives a total of 5% of compensation in contributions or dividends.

Is there any reason why this type of allocation formula would cause a qualification issue or create a prohibited transaction?

For purposes of discussion, ignore forfeitures and top-heavy considerations and assume that the plan complies with 401(a)(4) and 410(B) in operation (not including dividends in the test). If a participant's account receives dividends equal to more than 5% of compensation, the account still keeps the dividends.

Hi IRC401 ---

Use of dividends on employer stock to offset the stipulated allocation of employer contributions may violate the "exclusive benefit" rule of IRC section 401(a). This results from, in effect, using dividends attributable to some participants' accounts to satisfy the formula allocation of employer contributions to other participants' accounts.

If all of the "contributions" to the plan were made by means of dividends, it would seem that there wouldn't be "substanial and recurring" contributions to the plan.

(I realize that this isn't the fact pattern you stated, but this point is not wholly unrelated.)

Thank you for your responses.