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A recent tax law case involving Ralston Purina's ESOP highlights a riff between two courts.
Robert Willens, CFO.com | US
September 18, 2008
One of the more contentious tax issues that has cropped up over the past few years is the question of whether distributions in redemption of stock held by an Employee Stock Ownership Plan (ESOP) can be deducted by the distributing corporation. The view of the Internal Revenue Service is that these distributions cannot be deducted. However, some courts that have considered the question disagee.
First, it is important to look at one court that agrees with the IRS — the U.S. Tax Court, which continues to cling to its position that, by reason of the application of Section 162(k) of the Tax Code, the distributions are not deductible — although they constitute "applicable dividends." The court has recently reaffirmed its stance on this issue in Ralston Purina Company and Subsidiaries v. Commissioner, 131 T.C. No. 4 (2008).
In 1989, Ralston Purina amended its Savings Investment Plan (SIP) for employees, adding an ESOP feature to such plan. On February 1, 1989, the SIP purchased 4,511,414 shares of newly-issued convertible preferred stock from Ralston Purina at a price of $110.83 per share. To finance this purchase, the SIP borrowed some $500 million from institutional lenders.
Ralston Purina, as is typical of these arrangements, guaranteed the ESOP loan. In August 1994, the company redeemed 28,224 shares of preferred stock from the SIP for $3,128,066. The SIP, in turn, distributed the entire amount to terminating participants by December 31, 1994. Then, in February 1995, Ralston Purina redeemed 56,645 shares of preferred stock from the SIP for $6,277,965. All of the proceeds of this redemption were distributed to terminating participants during the period from February 21, 1995 through July 20, 1995.
The company claimed it was entitled to a deduction, under Section 404(k) of the tax code, for amounts it paid to the SIP to redeem its preferred stock that was then distributed to plan participants. Ralston Purina contended that the payments it made to the SIP, in redemption of a portion of the preferred stock held by the SIP, were "essentially equivalent to dividends" within the meaning of Section 302(b)(1). The IRS did not contest that conclusion. It did, however, vigorously contest the conclusion that the "redemption dividends" were deductible.
The tax code — specifically Section 404(k)(1) — states that in the case of a corporation, a deduction is allowed for a taxable year in the amount of any applicable dividend paid in cash by the corporation with respect to applicable employer securities. An applicable dividend is defined as any dividend which: (1) is paid in cash to the plan's participants or their beneficiaries; (2) is paid to the plan and is distributed in cash to participants or their beneficiaries not later than 90 days after the close of the plan year in which the dividend is paid; or (3) is used to make payments on a loan (the proceeds of which were employed by the ESOP to acquire employer securities) described in Section 404(a)(9) of the tax code.
The IRS, however, may disallow the deduction for any dividend (otherwise deductible) if it determines that such dividend "constitutes, in substance, an evasion of tax." (See Section 404(k)(5)(A).)
In addition, Section 162(k)(1) provides that no deduction otherwise allowable will be allowed for any amount paid or incurred by a corporation in connection with the redemption of its stock1. To be sure, the redemption dividends at issue here do not fall within any of the exceptions set forth in Section 162(k)(2).
In fact, in Boise Cascade Corp. v. United States, 329 F.3d 751 (9th Cir. 2003), the district court concluded that, with respect to a virtually identical transaction, that the ESOP was the owner of the redeemed stock. As a result, the redemptions did not result in a meaningful reduction of the ESOP's proportionate interest in the corporation, so the redemption distributions qualified for dividend treatment.
The court went on to say that "...the key question is whether distributions to ESOP participants were payments made in connection with the redemption of the preferred stock...." If they were, Section 162(k) would disallow a deduction for the amounts paid. The court, however, concluded that the payments (made by the ESOP to the plan participants) were not made in connection with the redemption of stock and, therefore, Section 162(k) did not operate to disallow a deduction for those payments.
The Boise Cascade court held, and Ralston Purina asserted, that the proper question for Section 162(k) purposes is whether the distribution payment (from the SIP to the plan's participants) is in connection with a redemption. The Tax Court, armed with this information, inferred that the Boise Cascade court believed that the distribution payment (from the SIP to the employees) was the payment for which taxpayer sought a deduction.
This belief, however, in the Tax Court's judgment, was patently incorrect. The Tax Court pointed out that the deduction sought is the Section 404(k) deduction. And Section 404(k) provides that a corporation is entitled to a deduction for applicable dividends. Thus, the proper question, for Section 162(k) purposes, is whether the applicable dividends are in connection with a redemption. Accordingly, Tax Court felt that the first order of business was to identify, with specificity, the transaction that constitutes the applicable dividend.
The court in Boise Cascade determined that the distribution payment (from the SIP to the plan participant) was the applicable dividend — an incorrect perception. Instead, it is the redemption payment and the distribution of that payment, as an integrated transaction, that constitutes the applicable dividend.
After all, an applicable dividend is any dividend which is (1) paid to the plan, and (2) distributed in cash to participants in the plan (not later than 90 days after the close of the plan year in which paid). Thus, the applicable dividend requires both a payment from the corporation and a distribution of that payment to departing employees. In short, distribution payments, from the SIP to terminating employees, standing alone, do not fit the definition of applicable dividends, and is therefore not deductible under Section 404(k).
In essence, the disagreement between the Ralston court and the Boise court is subtle, but important. The Ralston court is saying that the redemption payment and the distribution payment taken together is the deductible payment — and that payment is "in connection with a redemption." Whereas the Boise court is saying that the distribution payment is the deductible payment — and that payment is not "in connection with redemption."
In Connection With A Redemption
Having framed the issue in accordance with its reading of the statute, it became clear that the Tax Court was poised to rule against Ralston Purina. It did not disappoint. The court concluded that Ralston Purina's payments of the applicable dividends were certainly "in connection with" a redemption of stock and, hence, were rendered non-deductible by Section 162(k).
The first part of the applicable dividend transaction was the redemption. The funds of the transaction — passed from Ralston Purina to the SIP and then to the departing employees — are the same funds that were used to repurchase Ralston Purina's stock. And clearly, Section 162(k) bars a deduction for the payment of funds used to repurchase stock.
In short, the first component of the integrated transaction ensures that Section 162(k) bars the deduction of any portion of the transaction. The applicable dividends were, in the Tax Court's considered judgment, in connection with the redemption. In light of the fact that the courts are reaching diametrically opposite conclusions with respect to this issue, we may be heading, although not in the near future, to a Supreme Court resolution of the conflict.
In our view, however — although we are loath to admit it — the Tax Court's reasoning, derived from its careful reading of the statute, is correct and will wind up being the "law of the land" with respect to this issue. In summary, the redemption dividends constitute applicable dividends as defined in Section 404(k). However, these applicable dividends cannot be deducted because, within the meaning of Section 162(k), such applicable dividends are, unequivocally, "in connection with" a redemption.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 No deduction is allowed under Section 162(k)(1), except as provided in Sec. 162(k)(2).