Guest Article

(From the August 29, 2005 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

ESOP Dividends Paid Proposed Rules Emphasizes IRS Opposition to Boise Cascade Case

On August 25, 2005, the IRS released proposed regulations addressing two issues surrounding corporate deductions of dividends paid on stock held in Employee Stock Ownership Plans (ESOPs). 70 FR 49 897 (2005). Though ESOPs may benefit the employees of several related employers, the proposed regulations clarify that only the corporation making the dividend payments on its stock may take a deduction for such payments pursuant to IRC § 404(k). Additionally, the proposed regulations explain that a corporation may not take a deduction for payments in redemption of its securities held by an ESOP used to make benefit distributions to participants or beneficiaries. These proposed regulations formally reject the Ninth Circuit's interpretation of IRC §§ 162(k) and 404(k) in Boise Cascade v. United States, 329 F.3d 751 (9th Cir. 2003).

Background

IRC § 404(k) provides a C corporation a deduction for the amount of any "applicable dividend" paid in cash with respect to "applicable employer securities" held by an ESOP. An "applicable dividend" includes (but is not limited to) dividends paid in cash to the participants in the plan (or their beneficiaries) or paid to the plan and distributed in cash to participants or beneficiaries within 90 days of the close of the plan year in which the dividend was paid. IRC § 404(k)(2). A "dividend" is determined with reference to the relevant corporate law provision at IRC § 302.

An ESOP may be structured so as to cover the employees of several employers within a controlled group, and may be invested in the common stock of the participants' employer or any member of the same controlled group (as defined by reference to a modified version of the IRC § 1563 test). IRC §§ 409(l), 4975(e)(7). Where dividends were paid based on the stock of one company, but benefited the employees of another, the question remained as to which entity was entitled to the deduction under § 404(k). Though many believed that the only party entitled to the deduction would be the corporation upon whose stock the dividend was paid, PLR 200237026 (June 18, 2002) permitted a U.S. subsidiary to take the IRC § 404(k) deduction based on the dividends paid on its foreign parent's stock.

Additionally, questions remained as to the interaction of IRC § 404(k)'s boundaries and IRC § 162(k). IRC § 162(k) prohibits deducting amounts paid or incurred by a corporation "in connection with the reacquisition of its stock or the stock of any related person." In Boise Cascade, a company filed for a refund of taxes when it concluded that it could deduct amounts paid to redeem stock held by an ESOP, the proceeds of which were used to make benefit distributions to participants or beneficiaries (e.g., distributions of a participant's account balance). The district court sided in favor of the taxpayer. Before the appeal was heard (and subsequently affirmed) by the Ninth Circuit, the IRS issued Rev. Rul. 2001-6, 2001-1 C.B. 491, in which the IRS explained that IRC § 162(k) barred deduction because the redemption payments to the ESOP represented payments in connection with the reacquisition of the issuer's stock. Additionally, the IRS reasoned that because such deductions produced "anomalous results" (e.g., deduction for payments that do not represent true economic costs) the payments could not be considered "applicable dividends" under a reasonable reading of IRC § 404(k)(1). Lastly, the IRS invoked the authority it was granted under IRC § 404(k)(5) to disallow deductions that represented "an evasion of tax" and stated that any deduction of payments in redemption of employer securities used to make distributions to terminating ESOP participants would constitute an evasion of taxes. The IRS reaffirmed its view in Notice 2002-2, 2002-1 C.B. 285, which discussed some of the changes made to IRC § 404(k) by EGTRRA.

The IRS guidance notwithstanding, the Ninth Circuit agreed with the district court and concluded that the payments made to redeem the stock held by the ESOP were deductible as dividends under IRC § 404(k). The Ninth Circuit specifically addressed the IRC § 162(k) argument, concluding that the distributions to the employees were actually a separate obligation from the corporation's obligation to the ESOP to redeem the stock, and thus were not necessary or incident to the redemption in the manner contemplated by the statute. Therefore, the distributions to the participants were not "in connection with" the redemption of the stock. The IRS has never agreed with this position and has publicly stated that it would fight the position outside of the Ninth Circuit. See Chief Counsel Notice 2004-038 (Oct. 1, 2004).

The Proposed Regulations

The proposed regulations reverse the IRS private letter ruling under which a corporation may take a deduction for the payment of "applicable dividends" to ESOP participants; Prop. Treas. Reg. § 1.404(k)-2 explains that "only the corporation paying the dividend is entitled to the deduction with respect to applicable employer securities held by an ESOP."

The proposed regulations go to great lengths to reaffirm the IRS's position that it has maintained with respect to the deductibility of payments made to reacquire stock held by an ESOP. Proposed regulations under IRC § 162(k) state directly that the statutory language "in connection with the reacquisition" of stock refers to reacquisition from an ESOP, the proceeds of which are "used in a manner described in section 404(k)(2)(A)." Prop. Treas. Reg. § 1.404(k)-3 is then devoted exclusively to "disallowance of deduction for reacquisition payments." The regulation states expressly that such payments are not "applicable dividends" under the statute and that treatment of the payments as applicable dividends constitutes an avoidance or evasion of taxes (thus subject to disallowance).

All of the proposed regulations will apply at the time of finalization, but, as the IRS notes in the preamble to the proposed regulations, it continues to challenge the Boise-type deductions on the same grounds outlined in its prior guidance outside the Ninth Circuit.

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 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, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2005, Deloitte.