Tax deduction for ESOP stock redemptions.

It has been common practice for private companies that sponsor employee stock ownership plans (ESOPs) to purchase ESOP stock directly from former ESOP participants after the stock is distributed from the plan. This transaction is a nondeductible redemption because the participant's ownership of the employer is terminated (Sec. 302(b)(3)). An alternative strategy is to have the company redeem the stock from the ESOP, which then distributes cash to the participant. Such payments to the ESOP may be treated as dividends in certain circumstances. (While this analysis may also apply to public companies, the issue is less critical, because former ESOP participants usually sell their stock on the open market without any cost to the company.) The IRS's position, as reflected in two recent technical advice memorandums, presents an opportunity for ESOP sponsors to deduct redemption payments used by the ESOP to distribute cash to terminated participants.

In Letter Ruling (TAM) 9211006, the ESOP sponsor made a pro rata redemption of 90% of all outstanding stock held by the ESOP (30%) and an individual (70%); the ESOP used these proceeds to reduce its debt. The Service held that the redemption payment was a dividend under Sec. 301.

Under Sec. 404(k), a corporation can deduct an "applicable dividend" paid to an ESOP that is (1) used by the ESOP to reduce debt incurred to acquire its stock, (2) paid to participants by the ESOP within 90 days after the plan year in which the ESOP received the dividends or (3) paid directly to participants. Thus, a payment to an ESOP that is distributed to a terminating participant within 90 days after the year of payment can qualify as an applicable dividend.

Note, however, that a dividend deduction can be disallowed if it constitutes the "evasion" of taxation (Sec. 404(k)(5)(a)). The Conference Report to the Tax Reform Act of 1986 stated that "the deduction is to be allowed only with respect to reasonable dividends." In Letter Ruling (TAM) 9304003, the Service stated:

A comprehensive definition of a "reasonable" dividend (or one constituting an "evasion of taxation") is not found in the legislative history or in the income tax regulations. Nevertheless, if the ESOP and the other shareholders hold only common stock, a 'reasonable" dividend on such stock would not generally include an unusually large or "extraordinary" dividend used to repay ESOP debt if the dividend is greatly in excess of the dividend that the ESOP plan sponsor can reasonably be expected to pay on a recurring basis. A "reasonable" dividend within the meaning of section 404(k) of the Code contemplates a dividend of a rate that is normally paid in the ordinary course of business.

In Letter Ruling 9304003, the Service disallowed a deduction for the dividend described in Letter Ruling 9211006; it found that the dividend rate, 63.4% of the value of all the shares held by the ESOP, was unreasonable and well in excess of the previous year's dividend of 7%.

To summarize, the planning opportunity supported by Letter Rulings 9211006 and 9304003 involves a payment by an ESOP sponsor to the ESOP in exchange for all the stock in a terminating participant's account. Although the letter rulings involved the use of a "dividend" to repay ESOP debt, the deduction for the dividend applies equally if the dividend is used as a distribution to participants. Thus, the payment is not a redemption but a dividend that is distributed to the participant, and is, thereto, tax deductible.