Guest Article

(From the July 20, 2009 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Corporation's Stock Redemption Payments to ESOP Trust Not Deductible

The U.S. Court of Appeals for the Third Circuit affirmed a district court decision holding that a C corporation was not entitled to deductions under IRC § 404(k)(1) for payments made to its ESOP trust to redeem shares allocated to the accounts of ESOP participants who requested cash payouts upon the termination of their employment. The appeals court concluded that the deduction was disallowed under IRC § 162(k)(1). __________ v. United States, No. 07-3564 (3d Cir. July 13, 2009).

Background

IRC § 404(k)(1) allows a C corporation to deduct "the amount of any applicable dividend paid in cash by such corporation with respect to applicable employer securities." It defines an "applicable dividend" as "any dividend which, in accordance with the plan provisions . . . is paid to the plan and is distributed in cash to participants in the plan or their beneficiaries not later than 90 days after the close of the plan year in which paid."

The dispute in this case arises because of IRC § 162(k)(1), which provides that "no deduction otherwise allowable shall be allowed under this chapter for any amount paid or incurred by a corporation in connection with the reacquisition of its stock...."

Under the facts of the case, a C corporation employer created an employee stock ownership plan (ESOP) and related ESOP trust in 1989, and the trust purchased the corporation's preferred stock. Over time, those shares were allocated to employee-participants' ESOP accounts. When departing employee-participants elected to receive the value of their ESOP account balances in cash, the corporation redeemed the shares allocated to those participants' accounts; the corporation made cash payments to the ESOP trust in return for the redeemed shares, and the trust distributed the cash as benefit distributions.

The corporation claimed deductions under IRC § 404(k)(1) with respect to the amounts paid to the trust during the years 1994-2000. The IRS disallowed the deductions, and this refund suit followed.

Conflicting Authority

The first appellate court to decide this issue held that similar payments made by a corporation to redeem convertible preferred stock held by its employee stock ownership plan were deductible as dividends paid pursuant to IRC § 404(k) and that IRC § 162(k) did not bar the deduction. Boise Cascade Corp. v United States, 329 F.3d 751 (9th Cir. 2003). In determining the "applicable dividend," however, the Boise Cascade decision focused on the cash distribution from the ESOP trust to the former employees in concluding that the distributions were not "in connection with" the stock redemption.

The few decisions in subsequent cases, however, have favored the government, and the IRS has issued guidance rejecting the Boise Cascade decision. In Rev. Rul. 2001-6, the IRS ruled that "payments in redemption of stock held by an ESOP that are used to make distributions to terminating ESOP participants are not deductible." And in August 2006, the IRS and Treasury issued final regulations under IRC §§ 162(k) and 404(k) expressing continued disagreement with the decision in Boise Cascade.

The Tax Court, the only court with national jurisdiction to have addressed this issue, held more recently, in a case involving nearly indistinguishable facts, that no deduction was allowable. The Tax Court rejected the reasoning of Boise Cascade and concluded that the "applicable dividend" was an integrated transaction including both the redemption payment from the corporation to the plan and the distribution of that payment from the plan to the terminating participants. In other words, IRC § 162(k) applied because the cash that passed from the corporation to the plan and then to the departing employees was used to repurchase stock.

Third Circuit Decision

In __________ v. United States, the Third Circuit concluded that, even if the corporation's payments to the trust qualified as "applicable dividends" under IRC § 404(k)(1), the deduction was nonetheless barred by IRC § 162(k)(1) as payments "made in connection with the reacquisition of its stock." The court was unable to say, as the employer corporation had argued, "that a corporation's redemption payment to a trust, on the one hand, is made in connection with the reacquisition of stock but that, on the other hand, the trust's subsequent distribution of that payment is not so made."

Effect on Refund Claims

The Third Circuit decision adds to the growing authority (and creates an appellate majority) against taxpayers seeking refunds related to pre-August 2006 distributions.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Deborah Walker 202.879.4955. Copyright 2009, Deloitte.