July 16, 2012 The Tax Lawyer

ESOP Dividends: Arguments for Section 404(k) Dividend Deductions

Vol. 65, No. 2 - Winter 2012

David Eckhardt

Abstract

    Employers that maintain an employee stock ownership plan (ESOP) provide a method to compensate their employees while generating employee interest in the success of the employer. Congress acknowledged these benefits and passed certain tax-favorable legislation for companies that implement ESOPs to encourage their use. Unfortunately, by challenging taxpayers and issuing regulations, the Service does not share Congress’s view that certain dividends with respect to ESOPs are deductible.

    In 2010, the Eighth Circuit Court of Appeals ruled for the second time that certain dividends paid with respect to stock held by an ESOP were not deductible by an employer. The Eighth Circuit relied on its own precedent, the arguments in opinions by the Third Circuit, and the Tax Court. However, the Ninth Circuit previously reached a contradictory conclusion and allowed a deductions in different reasoning. The employer in the second Eighth Circuit case appealed to the Supreme Court, which subsequently denied certiorari. Thus, for any taxpayer employer that is still embattling challenges by the Service, the question is left to be resolved by each of the Circuit Courts of Appeals that have not ruled on the issue. Additionally, there may be some alternative methods to effectuate the same result with stronger arguments for deductibility.

    The issue in these cases revolves around the collision of several Code sections when a corporation effectuates a transaction involving ESOP dividends. It is common that a corporation will set up an ESOP for its employees as a method to compensate its employees for services rendered. As the employee provides services for the employer, the employee’s account in the ESOP will vest in the shares held by the plan, giving the employee an actual future interest in the ESOP. Thus, at some point in time, the employee will have a legal right to claim the vested amounts in the plan so the employee can actually use and enjoy the compensation from services the employee rendered.

    The initial catalyst of the transaction at issue occurs when the employee wishes to exercise his or her right in obtaining the vested amounts in the plan, which can occur when the employee terminates employment. By terminating employment, the employee also terminates participation in the ESOP.

    Through an employment agreement and under the terms of the plan, the employee becomes entitled to receive cash in the amount vested in the ESOP. Also by agreement, the employer will first distribute the money to the ESOP, with the plan subsequently distributing the money to the employee. Finally, the plan will require that the employer either redeem shares held by the ESOP equal to the participant’s account, or it must redeem shares from participants after the ESOP distributes the shares.

    Although the transaction appears relatively simple, several complicated issues require an analysis to determine whether the distribution by the employer is deductible to that corporation for income tax purposes. The Eighth Circuit, Third Circuit, and the Tax Court held—and the Service takes the position—that a corporation cannot deduct the distributions described above. This Article seeks to show how the Eighth Circuit, the Third Circuit, and the Tax Court illogically reached that conclusion. First, Part II of this Article provides information on ESOPs and certain payments that are deductible to the employer when compensating its employees. Part II also provides background information on the nondeductibility of payments made for redemption of stock, as well as the various cases that have ruled on this issue. Next, Part III examines the structure of existing judicial analysis of the issue. Part III also analyzes the relevant Code sections to show how the courts were incorrect in analyzing the issue. Part IV describes fact patterns and alternate methods that vary from the court cases and provides an analysis for deductibility in those scenarios. Finally, Part IV analyzes how the remaining Circuit Courts of Appeals that have not ruled on the issue should rule based on this Article’s analysis and the courts’ precedent.

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