Deduction for ESOP Distributions Disallowed

By James Beavers, J.D., LL.M., CPA

In a decision that creates a circuit split, the Eighth Circuit reversed a district court and held that a corporation was not entitled to a deduction for cash distribution redemptive dividends paid by the corporation’s employee stock ownership plans to plan participants who left the corporation.

Background

General Mills, Inc. (GMI) established three employee stock ownership plans (ESOPs). A single trust (the trust) held the ESOPs’ assets, primarily GMI common stock. GMI contributed to the ESOPs for the benefit of participating employees.

When a participant left GMI, the trust distributed, in cash or stock, the value of the participant’s ESOP account. If a participant elected cash, the trust could request that GMI purchase company stock from the trust, paying the trust a dividend known as a redemptive dividend. From the redemptive dividend, the trust could distribute a cash distribution redemptive dividend (CDRD) as part of the total cash distributed to the participant.

GMI sued for a refund equal to the value of deductions for its CDRDs (almost $5 million), arguing that Sec. 404(k)(1) allowed a deduction for them. The IRS countered that Sec. 162(k)(1) or, alternatively, Sec. 404(k)(5) barred any deduction allowed by Sec. 404(k)(1).

The Deduction for Applicable Dividends

Sec. 404(k)(1) allows as “a deduction for a taxable year the amount of any applicable dividend paid in cash by such corporation with respect to applicable employer securities.” An applicable dividend includes “any dividend which, in accordance with the plan provisions . . . is paid to the plan and is distributed in cash to participants in the plan or their beneficiaries not later than 90 days after the close of the plan year in which paid” (Sec. 404(k) (2)(A)(ii)). The corporation may claim the deduction only for a tax year in which the participant receives cash (Sec. 404(k)(4)).

Payments by a corporation to participants (such as those made by GMI), routed through a trust, are applicable dividends under Sec. 404(k)(2)(A)(ii). The corporation, not the trust, is the entity (“such corporation”) claiming the Sec. 404(k)(1) deduction. The corporation’s payment of the redemptive dividend to the trust does not by itself qualify for a Sec. 404(k)(1) deduction (nor does an independently funded cash distribution by the trust to a participant). Thus, the Sec. 404(k)(2)(A) (ii) transaction is a two-step process.

The District Court’s Holding

The issue before the district court was whether Sec. 162(k)(1) barred GMI from taking the deduction allowed by Sec. 404(k)(1). Sec. 162(k)(1) states that “no deduction otherwise allowable shall be allowed under this chapter for any amount paid or incurred by a corporation in connection with the redemption of its stock.” The district court ruled that Sec. 162(k)(1) does not bar the Sec. 404(k)(1) deduction.

Noting that Sec. 162(k)(1) applies to a deduction that is “otherwise allowable,” the district court reasoned that Sec. 404(k)(1) does not allow a deduction for a redemptive dividend alone, but only for that portion of the redemptive dividend distributed in cash to participants. Accordingly, when applying Sec. 162(k) (1), the court focused exclusively on the CDRD, not on the two-step applicable dividend defined in Sec. 404(k)(2)(A)(ii).

Further, looking at the “in connection with” requirement of Sec. 162(k)(1), the court, citing Boise Cascade Corp., 329 F.3d 751 (9th Cir. 2003), found that a deduction for payments was barred for being in connection with a stock redemption only if the payments were “necessary and incident” to the redemption. The district court found in GMI’s case that because the trust had an independent duty to pay the participants, the CDRDs were not necessary and incident to the redemptions and therefore a deduction for the CDRDs was not barred under Sec. 162(k)(1).

The Eighth Circuit’s Holding

The Eighth Circuit reversed the district court and held that the CDRDs were not deductible per Sec. 162(k)(1). According to the Eighth Circuit, the district court failed to recognize that the “deduction otherwise allowable” that is barred by Sec. 162(k)(1) is the deduction for the “applicable dividend” defined in Sec. 404(k)(2)(A)(ii).

The court found that an applicable dividend is a redemptive dividend combined with a CDRD and that neither step alone qualifies as an applicable dividend. Therefore, because, as GMI acknowledged, a redemptive dividend is “in connection with” a stock redemption, when a redemptive dividend is combined with a CDRD to form an applicable dividend, the applicable dividend is in connection with a stock redemption. Therefore, Sec. 162(k) (1) bars the deduction for an applicable dividend.

The Eighth Circuit found that the Ninth Circuit had come to its conclusion in Boise Cascade by improperly giving a narrow construction to the phrase “in connection with” in Sec. 162(k)(1) based on its analysis of the legislative history. The Eighth Circuit noted that the relevant conference report stated directly that the phrase was intended to be construed broadly and that the relevant House and Senate committee reports did not indicate that Sec. 162(k)(1) was intended to bar only deductions for expenditures “necessary and incident” to stock redemptions.

General Mills, Inc., No. 08-1638 (8th Cir. 1/26/09)

The reports of cases, rulings, etc., herein, except for the Reflections, are edited versions of the relevant court opinion, published ruling, etc.

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