August 31, 2012 The Tax Lawyer

Irreconcilable Differences: ESOP Disincentives Created by the Conflicting Demands of Sections 404(k) and 162(k)

Vol. 65, No. 3 - Spring 2012

Danielle Gershowitz

Abstract

    Employee stock ownership plans (ESOPs) serve the interests of both employees and employers by providing a benefit plan to employees and tax savings to employers. Section 404(k) was enacted to encourage employers to create and contribute to ESOPs, but section 162(k) removed a tax incentive for employers to create ESOPs. In Nestle Purina Petcare Co. v. Commissioner, the taxpayer claimed a deduction for payments made to its ESOP, but the deduction was denied. The payments were used to redeem the company’s preferred stock to make cash distributions to employees terminating their participation in the plan. The implications of Nestle Purina and other cases involving such cash distribution redemptive dividends (CDRDs) highlight the need for Congress to clarify its position regarding the tax treatment of CDRDs.

    The taxpayer in Nestle Purina was denied a deduction for applicable dividends allowed under section 404(k) because the court reasoned that section 162(k) barred the deduction. The Eighth Circuit held that the dividends were distributed “in connection with” the reacquisition of the company’s stock in contravention of section 162(k), and that the transaction did not qualify as an exception under section 162(k)(2)(A)(iii). Nestle Purina is the latest case to disallow a deduction for CDRDs because of the irreconcilable tension between sections 404(k) and 162(k).

    This Note argues that the Eighth Circuit’s decision in Nestle Purina correctly interpreted section 162(k) to hold that the taxpayer’s claimed deduction under section 404(k) was barred because it did not fit the exception for a dividend paid under section 162(k)(2)(A)(iii). However, the correct interpretation might not lead to the best result. By denying the taxpayer’s claim, the court reinforced its position, and that of several other circuits, that section 162(k) bars deductions for CDRDs as applicable dividends under section 404(k). While the holding follows the plain meaning of the Code, it reveals the faulty drafting of the provisions, because section 162(k) detracts from the tax incentive created by section 404(k). Congress should continue to incentivize employers to create ESOPs by amending section 162(k) to allow a deduction for CDRDs.

    Part II of this note presents an overview of ESOPs, the relevant statutory provisions, and the line of cases dealing with CDRDs. Part III examines the transaction at the heart of Nestle Purina and discusses the rationale behind the Eighth Circuit’s decision to deny the deduction. Part IV analyzes the court’s opinion and argues that it was correct. Finally, Part V evaluates the benefits of ESOP tax incentives and the need for Congress to relieve the tension between sections 404(k) and 162(k) by allowing a deduction for CDRDs.

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