Tax News

CCH (cch.taxgroup.com) reports:

  A corporation that redeemed shares of its common stock held by a trust that in turn used the proceeds to satisfy distributions to terminated employees who cashed out of an employee stock ownership plan (ESOP) was not entitled to a tax deduction under Code Sec. 404(k)(1) for the payments to the employees.

  Under the terms of the ESOPs set up by the corporation, when a participant left the corporate employer, the ESOP trust distributed to the participant in cash or stock the value of the participant's ESOP account. If the participant elected cash, the trust would ask the corporation to purchase its own stock from the trust to fund the distribution. The corporation would buy the stock and make the payments (which the parties agreed were equivalent to dividends for purposes of Code Secs. 301 and 316). The trust then distributed the cash to the participant.

  These two steps - the payment of a dividend to the trust followed by the distribution of the amount to the participant - meant that the payments were applicable dividends under Code Sec. 404(k)(2)(A)(ii), and such dividends are normally deductible under Code Sec. 404(k)(1). However, Code Sec. 162(k)(1), which prohibits otherwise allowable deductions by a corporation for amounts paid in connection with reaquiring its own stock, prohibited the corporation from claiming the deduction.

  CCH Comment. The IRS pointed out in Rev. Rul. 2001-6, 2001-1 CB 491, which prohibited a deduction under a similar set of facts, that application of Code Sec. 404(k) to redemption amounts would allow employers to claim deductions for payments that do not represent true economic costs, and it would eliminate important rights and protections for recipients of ESOP distributions, including the right to reduce taxes by using the return of basis provisions under Code Sec. 72, the right to make rollovers of ESOP distributions received upon separation from service, and the protection against involuntary cash-outs.

  CCH Comment. The court declined to follow the Ninth Circuit's decision in Boise Cascade Corp. , CA-9, 2003-1 USTC ¶50,472; rather, it is in line with the Tax Court's recent decision in Ralston Purina Co. , 131 TC --, No. 4, Dec. 57,534, as well as
Reg. §§1.62(k)-1(c), and 1.404(k)-3, which the IRS issued in response to Boise . The district court's take in General Mills, Inc. , DC Minn., 2008-1 USTC ¶50,141, essentially followed the holding in Boise Cascade that Code Sec. 162(k)(1) would only apply, if at all, to the initial step (the payment made to the trust in the stock repurchase), which by itself is not otherwise deductible.

  Also, the district court concluded that Code Sec. 162(k)(1) only prohibits deductions for fees and expenses that are necessary and incident to the repurchase of the stock, rather than the amount paid for the stock itself. The Court of Appeals rejected both positions.

  CCH Comment. An approach not taken by the Court of Appeals was to use Code Sec. 404(k)(5)(A), under which the IRS can disallow a Code Sec. 404(k)(1) deduction for tax-avoidance reasons. This was the approach advocated by the concurring opinion in Ralston Purina .

  Reversing and remanding a DC Minn. decision, 2008-1 USTC ¶50,141.

General Mills, Inc. & Subsidiaries, CA-8, 2009-1 USTC ¶50,177

Other References:

 
Code Sec. 162

  CCH Reference - 2009FED ¶9052.01

  CCH Reference - 2009FED ¶9052.23

 
Code Sec. 404

  CCH Reference - 2009FED ¶18,371.30

  Tax Research Consultant

  CCH Reference - TRC RETIRE: 75,204