The U.S. Court of Appeals for the Ninth Circuit recently held that payments made by a corporation to redeem shares of its stock held in an Employee Stock Ownership Plan (ESOP) and distributed by the ESOP to participants were deductible under section 404(k) of the Internal Revenue Code (Code). The court also held that the deductions were not barred by section 162(k)(1) of the Code. Partner William L. Goldman, led the McDermott Will & Emery team that represented the taxpayer in this litigation.
Boise Cascade Corporation maintained an ESOP that owned Boise Cascade convertible preferred stock. When participants in the ESOP terminated employment, Boise Cascade redeemed convertible preferred stock equal in value to the participants’ vested account balances for cash. Terminating participants who so elected or who had account balances of less than $3,500 then received distributions in cash from the ESOP equal to their account balances. Alternatively, the participants could elect to have the cash reinvested in another investment fund held by the retirement plan.
The Ninth Circuit first held that the convertible preferred stock was owned by the ESOP, not the participants. Consequently, the redemptions were essentially equivalent to dividends paid by Boise Cascade within the meaning of section 302(b)(1) of the Code, because the redemptions did not result in a "meaningful reduction" of the ESOP’s overall interest in the company.
Section 404(k) of the Code provides that, if a corporation pays a dividend to an ESOP and the ESOP distributes the dividend in cash to its participants or uses the cash to make payments on stock acquisition loans, the corporation may deduct the amount of that dividend. In this case, once the redemption payments were found to be dividends under section 302(b)(1) of the Code, the portions that were distributed to participants could be deducted under section 404(k). Boise Cascade agreed that no deduction was allowable for the undistributed redemption payments.
The Ninth Circuit also held that these deductions were not barred by section 162(k)(1) of the Code, which denied deductions otherwise allowable under the Code for payments made in connection with the redemption of stock. Section 162(k)(1) was held to be inapplicable because the subsequent distributions from the ESOP to the participants were not in connection with the stock redemptions.
What does this case mean for companies with ESOPs? Some companies may be able to claim deductions that they did not realize existed. However, securing these deductions is not a sure thing. Before claiming such a deduction, an employer should consider the following:
• ESOP distributions in question must arise because the company redeems stock from the ESOP for cash, which the ESOP then distributes to participants. If the ESOP distributes stock to participants who then sell the stock back to the company, keep it or sell it on the market, no deduction may be claimed.
• Not every redemption of stock from an ESOP will be considered to be essentially equivalent to a dividend under section 302(b)(1) of the Code. If redemptions result in a meaningful reduction in the ESOP’s ownership interest, the redemptions will not constitute dividends under section 302(b)(1) of the Code.
• Before this decision was announced, the IRS published Rev. Rul. 2001-6, 2001-1 C.B. 491, which states that 404(k) deductions for the redemption of shares are not allowed. Any taxpayer claiming a deduction on an original return contrary to the position expressed in Rev. Rul. 2001-6 should consider the requirement to disclose this fact on its tax return.
• Deductions may be claimed by filing amended returns for prior years that are still "open" under the statute of limitations.
• Any such deduction would be allowable only for years in which the employer is taxed as a C corporation. A company that is now an S corporation might be able to file an amended return claiming the deduction for prior C corporation years, if the other conditions are satisfied.
• Dividends that are paid to participants and deducted under section 404(k) are generally not eligible for tax-free rollover to an IRA or another qualified plan. However, they are not subject to the 10 percent early distribution tax under section 72(t) of the Code. By contrast, regular qualified plan distributions are generally eligible for tax-free rollover treatment and could be subject to a 10 percent early distribution tax. An employer may, if it wishes, design a distribution procedure to permit employees who so desire to obtain a tax-free rollover, while claiming a section 404(k) deduction under Boise Cascade for distributions to the other employees, who also would be exempted from the 10 percent early distribution tax.
Employers considering the implications of this case should carefully analyze all of the various legal and practical considerations that could arise.