Employee Benefits-Third Circuit Rules That Payments To An ESOP To Redeem Stock Are Not Deductible Due To Code Section 162(k)(1)

In Conopco, Inc. v. United States of America, No. 07-3564 (3rd Cir. 2009), the Third Circuit ruled that the taxpayer could not deduct approximately $13.8 million in payments it had made to its employee stock ownership plan (the “ESOP”) to redeem stock of departing participants, due to Section 162(k)(1) of the Internal Revenue Code.

In this case, the ESOP’s trust (the “Trust”) had purchased 2.2 million shares of voting convertible preferred stock (the “Shares”) from Conopco, Inc. (“Conopco”), using funds the Trust had acquired by issuing bonds. Under the ESOP’s terms, the Shares were allocated to the employee-participants’ accounts. When a participant ended his or her employment with Conopco, the participant could generally choose to receive the value of the Shares in a number of forms, including cash. If the participant elected to receive the cash, Conopco would redeem the Shares which had been allocated to the participant’s account in the ESOP by making a cash payment to the Trust to buy back the Shares, and then the Trust would distribute the cash to the participant, within 90 days of the close of the plan year of the redemption by Conopco.

The question before the Court is whether the payments by Conopco to redeem the Shares are deductible under Section 404(k)(1). The Court stated that Section 404(k)(1) allows a C corporation, such as Conopco, to claim “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.” In turn, under Section 404(k)(2)(A)(ii), an “applicable dividend” is defined in relevant part as “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.” However, Section 162(k)(1) of the Internal Revenue Code provides that “no deduction otherwise allowable shall be allowed …for any amount paid or incurred by a corporation in connection with the reacquisition of its stock.”

The Court concluded that the payments in question (assumed to be “applicable dividends” for purposes of Section 404(k)) could not be deducted because of Section 162(k)(1), since the payments had been made for the reacquisition of its stock. This obtains even though the distribution of cash from the Trust to the participant, by itself, is not a reacquisition, as the distribution cannot be separated from payment to the Trust to redeem the Shares when applying Section 162(k)(1). This is particularly so, since Section 404(k) itself requires, for a deduction to be allowable, a payment of a dividend to the plan coupled with a distribution of cash to participants. The payments in question had been made prior to 2001, but the Court noted in a footnote that, for payments made on or after August 30, 2006, its conclusion on the issue may be bolstered by Treasury Regulation section 1.162(k)-1, which states that amounts paid or incurred in connection with the reacquisition of stock include amounts paid by a corporation to reacquire its stock from an ESOP that are used in a manner described in section 404(k)(2)(A) (that is, generally, the amounts are ultimately paid in cash to the plan participants).