When Is a Dividend Deductible?

A recent tax law case involving Ralston Purina's ESOP highlights a riff between two courts.

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.

Applicable Dividends

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).)

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