No deduction for high-rate dividend used to pay off ESOP loan.
Corporation set up a qualified leveraged ESOP in 1986, using back-to-back loans from Bank to Corporation and then from Corporation to the ESOP. The ESOP used the loan proceeds to buy, at $10 a share, 30% of Corporation's stock from Seller, who had previously owned all of Corporation's stock. After the sale, the ESOP owned 150,000 shares and Seller owned the remaining 350,000. In 1988, the following series of events occurred. * An unrelated corporation bought 35,000 of Seller's 350,000 shares. * Corporation redeemed Seller's remaining 315,000 shares at their current fair market value of $12 a share. * Corporation redeemed 135,000 of the ESOP's 150,000 shares at $12 a share. * The ESOP used part of the redemption proceeds to pay off the exempt loan.
After these transactions, the ESOP continued to own 30% of Corporation, but the number of shares it held was reduced by 90%, from 150,000 shares to 15,000 shares. In a 1991 technical advice memorandum, the IRS had ruled that the redemption proceeds the ESOP received constituted a dividend. Corporation claimed a deduction under Sec. 404(k) for that part of the dividend the ESOP used to pay off the exempt loan.
Sec. 404(k)(2)(A)(iii) allows a deduction for dividends paid on stock held by an ESOP and used to make payments on an ESOP loan. Sec. 404(k)(5)(a) and the Conference Report to the Tax Reform Act of 1986 (in which this deduction was enacted) state that the Treasury may disallow the deduction for any dividend paid on stock held by an ESOP if the dividend constitutes, in substance, the evasion of taxation. The Conference Report further stated that "[t]he conferees intend that the deduction is to be allowed only with respect to reasonable dividends."
According to the Service, if the ESOP and the other shareholders held only common stock, a "reasonable" dividend on that stock would not have generally included an "unusually large" or "extraordinary" dividend used to repay an ESOP loan if the dividend greatly exceeded the dividend the sponsor could reasonably be expected to pay on a recurring basis. "Reasonable" under Sec. 404(k) contemplates a dividend rate that is normally paid in the ordinary course of business.
The IRS recognized that there are several approaches that could be used to calculate a dividend rate to determine if the rate was reasonable. But even using the approach that would result in the lowest dividend rate (dividing the claimed dividend by the value of all the ESOP's shares), the Service calculated a dividend rate of 63.4%, substantially higher than the rate Corporation could reasonably be expected to pay on its common stock on a recurring or continuing basis. Thus, the 63.4% rate was "extraordinary"--especially when compared to the 7% dividend paid in the preceding plan year. Consequently, the IRS concluded that the dividends used to pay off the ESOP loan were not deductible under Sec. 404(k).
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||exempt employee stock option plan|
|Author:||Yurkovic, Denis L.|
|Publication:||The Tax Adviser|
|Date:||Jun 1, 1993|
|Previous Article:||Payment for suicide allegedly caused by job stress is excludible.|
|Next Article:||Can a 401(k) plan be a qualified replacement plan?|