The Third Circuit Court of Appeals joined the Eighth Circuit in ruling that even if cash payments to redeem employee stock ownership plan (ESOP) accounts are otherwise deductible dividends within the meaning of IRC § 404(k), an employer is barred by section 162(k)(1) from deducting the payments if they are made in connection with the reacquisition of its stock.
The decision involved an ESOP established by Conopco Inc. The company, with roots in mayonnaise brands Best Foods and Hellmann’s, is a wholly owned subsidiary of food and personal care product conglomerate Unilever USA. The facts and result closely mirrored a decision earlier this year by the Eighth Circuit in the case of another food giant, General Mills Inc. v. U.S. (554 F.3d 727 (2009); see “Tax Matters: Deduction Denied for ESOP Stock Redemption,” JofA, May 09, page 65), which the Third Circuit cited prominently.
Conopco established a trust to implement an ESOP in 1989 with 2.2 million shares of its voting convertible preferred stock. When participants who ended their employment with Conopco elected to receive the value of their ESOP account balances as cash payments, Conopco would redeem the preferred stock that had been allocated to those participants’ accounts by paying the trust to buy back the shares. Conopco deducted the cost of the stock redemption as a dividend paid to the ESOP. The IRS objected, and the District Court for New Jersey granted summary judgment in the government’s favor.
Section 404(k)(1) provides that a corporation can deduct cash dividends paid to an ESOP that are distributed to ESOP participants, a requirement the district court concluded that Conopco met. But section 162(k)(1) denies a deduction for amounts otherwise deductible if they are incurred in connection with a corporation’s reacquisition of its own stock. The court ruled that this section denied Conopco its deduction. Conopco appealed, arguing that the distribution gave rise to the deduction, and it was not incurred in relation to the stock redemption.
The Third Circuit agreed with the district court, saying the redemption and distribution must be treated as a single transaction. The court noted that this single-transaction conclusion, while followed by the Eighth Circuit in General Mills and the Tax Court in Ralston Purina Co. v. Commissioner (131 TC no. 4), is contrary to the Ninth Circuit decision in Boise Cascade Corp. v. U.S. (329 F.3d 751 (2003)).
Conopco Inc. v U.S. , docket no. 07- 3564 (3rd Cir.)
By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accounting, University of Alabama, Tuscaloosa.