ESOP stock redemption payment was a deductible dividend.
Boise Cascade is an integrated forest products and office products company headquartered in Boise, ID. It maintained the Boise Cascade Supplemental Retirement Plan, which was converted into an ESOP on May 25, 1989. On July 10, 1989, Boise's board created a new series of convertible preferred stock especially for the ESOP. The stock could only be issued to the ESOP's trustee; if transferred to anyone else, it would automatically convert into common stock. The ESOP bought all the convertible preferred stock with funds borrowed from banks and the corporation.
When a plan participant left employment, the ESOP redeemed convertible preferred stock equal in value to the participant's vested account, regardless of any election by the participant on the ultimate distribution of the account balance (Boise Cascade decided whether the redemption was to be in cash or common stock). A plan participant had various immediate and deferred distribution options. However, participants with $3,500 or less in their accounts were cashed out.
During 1989, participants with vested account balances totaling 507.336 shares of convertible preferred stock terminated employment. The ESOP shares were redeemed by the corporation as required by the trustee. Most of the cash paid by the corporation for the convertible stock was distributed to participants who elected to receive cash or common stock, and each received a Form 1099.
On Dec. 12, 1989, the board declared a dividend on the ESOP's stock of over $11 million. The dividend was used by the ESOP trustee to repay the ESOP's loan. The excess amount was deducted by the corporation under Sec. 404(k), which the IRS allowed.
On Nov. 18, 1996, the corporation filed an amended return for 1989, claiming a $1,724 refund (later reduced to $840). The claim was for the convertible preferred stock it redeemed to pay plan participants. In a letter dated March 17, 1997, the IRS refused to refund the money.
District Court's Decision
Boise Cascade sued the IRS for a refund, in district court. The court affirmed a report by a magistrate judge who concluded that the redemption payments qualified as dividends under Sec. 302(b); thus, they were deductible under Sec. 404(k), and the deduction was not barred by Sec. 162(k)(1).The IRS appealed.
Ninth Circuit's Decision
The Ninth Circuit began its analysis by noting that dividends are not usually deductible. However, under Sec. 404(k), a deduction was permitted (before the Economic Growth and Tax Relief Reconciliation Act of 2001) for dividends paid on ESOP stock that was:
1. Paid in cash to plan participants or beneficiaries;
2. Paid to the ESOP and then distributed to participants or beneficiaries within 90 days of the plan year-end; or
3. Used to make payments on the ESOP's loan.
The Ninth Circuit held that the district court correctly concluded that the payments were Sec. 404(k) deductible dividends.
There was no dispute that the 1989 payments went to plan participants. The amounts paid were distributed from current or accumulated earnings and profits, as required by Sec. 316(a) for an amount to be a "dividend" Sec. 316(a) refers to Sec. 301, which provides that a property distribution by a corporation to a stockholder is included in gross income to the extent the payment is a dividend.
Sec. 302 governs stock redemptions. Under Sec. 302(d), a stock redemption is a dividend. However, if Sec. 302(a) applies, it is treated as an exchange for stock, not as a dividend. Sec. 302(b) notes four situations in which redemptions will be treated as exchanges. In Boise Cascade, both the IRS and the taxpayer agreed that only Sec. 302(b)(1), under which a redemption "not essentially equivalent to a dividend" would be treated as an exchange, could apply to the facts.
Key to the decision: The Ninth Circuit cited Davis, 397 US 301 (1970), in which the Supreme Court established that Sec. 301(b)(1) applies only when redemption results "in a meaningful reduction in the shareholder's proportionate interest in the corporation." In Boise Cascade, both sides agreed that for Sec. 302(b) purposes, if the ESOP trust is treated as the owner of the convertible preferred stock redeemed in 1989, then the reduction in the ESOP's interest in the corporation was not meaningful, and the payments were a deductible dividend. However, if the ESOP'S participants are treated as the stock owners, then there is a meaningful reduction in their interests; thus, the redemption was not a dividend and not deductible under Sec. 404(k).
Who owns the stock? The Ninth Circuit wrote, "[i]n short, the question of whether the distributions to Participants in this case are deductible dividends under 404(k) depends on whether the Trust or the Participants owned the convertible preferred stock when the redemptions took place." It found that the district court correctly ruled that the ESOP trust owned the shares.
Sec. 302(c)(1) refers to Sec. 318(a) for purposes of determining ownership. Under Sec. 318(a)(2)(B)(i), in a trust (except a Sec. 401(a) qualified trust), the beneficiaries are treated as owning the trust's corpus. The ESOP is a qualified trust; thus, the ESOP, not its beneficiaries, is deemed to own the convertible preferred stock. The redemption did not materially reduce the ESOP's stake in Boise Cascade; thus, it was a dividend deductible under Sec. 404(k).
Sec. 162(k): This provision prohibits deductions for payments made in connection with a stock redemption. According to the legislative history, this section was enacted to clarify that all expenditures by a corporation incurred in buying its own stock are nonamortizable capital expenditures; see H Rep't No. 99-426, 99th Cong., 2d Sess. (1986), p. 248. The Ninth Circuit did not apply Sec. 162(k), because the case involved two distinct transactions:
1. The stock redemption by the corporation; and
2. The subsequent distributions by the ESOP trustee.
The two issues, wrote the court, "are not ineluctably linked." In fact, it decided that the transactions were entirely separate; even though, under the ESOP, a convertible preferred stock redemption was required when a person left the company, a distribution did not automatically follow. Further, the redemption was not a prerequisite for a distribution, because a participant could defer distributions under the ESOP's terms. Thus, the distributions were not "in connection" with the redemption; thus, a deduction was not barred by Sec. 162(k).
Rev. Rul. 2001-6
The IRS issued Rev. Rul. 2001-6 after its loss in district court. The ruling holds that payments in redemption of stock held by an ESOP and used to make distributions to terminating ESOP participants are not deductible. In addition, they are not "applicable dividends" deductible under Sec. 404(k).
Rev. Rul. 2001-6 relies on Sec. 162(k)(1), which the Ninth Circuit found inapplicable. It also states that treating stock redemption payments as deductible dividends under Sec. 404(k) would produce "anomalous" results. This assertion finds its authority in Helvering v. Hammel, 311 US 504 (1941), which stated the "words of a statute must be given a restricted rather than literal or usual meaning ... where acceptance of that would lead to absurd results ... or would thwart" the statute's obvious intent.
Current State of Affairs
Although the Ninth Circuit did not mention Rev. Rul. 2001-6 in its decision, it seems to have implied that it is an incorrect interpretation of the law.
It appears from CC 2004-038 that the IRS will follow Boise Cascade in the Ninth Circuit, while enforcing Rev. Rul. 2001-6 in the rest of the country. As a result, IRS agents in the Ninth Circuit are directed to coordinate with the National Office before challenging stock redemption deductions under Sec. 404(k). The notice is dated Oct. 1, 2004 and is "effective until further notice."
There is no doubt that more will be heard from the IRS on this issue.
FROM ROBERT H. MASNIK, J.D., WASHINGTON, DC
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|Title Annotation:||employee stock ownership plan|
|Author:||Masnik, Robert H.|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 2005|
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