IRS Revenue Ruling
2001-6

Code Sec. 491

<<FULL TEXT>>

Deductibility of payments in redemption of stock held by an employee
stock ownership plan. This ruling holds that payments in redemption of
stock held by an ESOP that are used to make distributions to terminating
ESOP participants are not deductible and that such payments do not
constitute "applicable dividends" under section 404(k)(1) of the Code.


REV. RUL. 2001-6

ISSUE

Whether payments in redemption of stock held by an ESOP that are used
to make distributions to terminating ESOP participants constitute
"applicable dividends" under section 404(k)(1) of the Internal Revenue
Code that are deductible.


FACTS

Corporation A (a C corporation) has a single class of voting common
stock outstanding. Corporation A maintains an employee stock ownership
plan (ESOP), as defined in section 4975(e)(7) of the Internal Revenue Code
(Code), which holds stock of Corporation A. The terms of the ESOP provide
that when Corporation A pays dividends on its stock, the ESOP trustee may
1) allocate the dividends on the employer securities in a participant's
account to the participant; 2) allocate the dividends on the employer
securities in a participant's account to the plan and distribute it in
cash to the participant not later than 90 days after the close of the plan
year in which paid; or 3) use the dividends on employer securities
allocated to a participant's account to repay a loan to the ESOP the
proceeds of which were used to acquire the employer securities, provided
that employer securities with a fair market value at least equal to the
value of those dividends are allocated to the participant's account.

Under the plan, participants may elect to take a distribution in cash
or stock at retirement or termination of employment. In the current year,
100 participants with account balances from $2,000 to $200,000, totaling
$5 million, separate from service, become eligible for distributions from
the ESOP, and elect cash distributions. As allowed under the plan,
Corporation A redeems the shares in the terminating participants' accounts
for $5 million immediately prior to the distributions. Corporation A
claims that the redemptions are treated as dividends under the applicable
rules of sections 301, 302, and 316.

The ESOP pays the $5 million redemption proceeds to the terminating
participants within 90 days after the close of the plan year in which the
plan received the proceeds.


LAW AND ANALYSIS

Section 162(k)(1) provides, with exceptions not relevant here, that no
deduction otherwise allowable under Chapter 1 is allowed for any amount
paid or incurred by a corporation in connection with the reacquisition of
its stock or of the stock of any related person (as defined in section
465(b)(3)(Q.

Section 404(k)(1) of the Code provides that, in the case of a C
corporation, there is allowed as a deduction for a taxable year the amount
of any applicable dividend paid in cash by such corporation during the
taxable year with respect to applicable employer securities. This
deduction is in addition to the deductions allowed in section 404(a).

Section 404(k)(2)(A) provides, in relevant part, that the term
"applicable dividend" means any dividend which, in accordance with 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.

Under section 404(k)(4), the deduction is allowable in the taxable year
of the corporation in which the dividend is paid or distributed to a
participant or beneficiary.

Section 404(k)(5)(A) provides that the Secretary may disallow the
deduction under paragraph (1) for any dividend if the Secretary determines
that such dividend constitutes, in substance, an evasion of taxation.

Under these facts, redemption payments are paid in connection with the
"reacquisition" of the issuer's stock. Thus, section 162(k)(1) bars the
deduction of such payments without regard to whether they would otherwise
be deductible under section 404(k).

Moreover, the treatment of redemption proceeds as "applicable
dividends" under section 404(k) would produce such anomalous results that
section 404(k) cannot reasonably be construed as encompassing such
payments. See, e.g., Helvering v. Hammel, 311 U.S. 504, 510-511 (1941)
(the words of a statute must be given "a restricted rather than a literal
or usual meaning . . . where acceptance of that meaning would lead to
absurd results . . . or would thwart the obvious purpose of the statute.")
The application of section 404(k) to redemption amounts not only would
allow employers to claim deductions for payments that do not represent
true economic costs, but also would vitiate important rights and
protections for recipients of ESOP distributions, including the right to
reduce taxes by utilizing the return of basis provisions under section 72,
the right to make rollovers of ESOP distributions received upon separation
from service, and the protection against involuntary cash-outs. See
sections 72(e)(5)(D) and 411(a)(11)(C); section 1.402(c)-2, A-4(e) of the
Income Tax Regulations. Therefore, the term "applicable dividends" under
section 404(k) does not include amounts paid for the redemption of stock
held by an ESOP, whether or not such redemption proceeds constitute
dividends under sections 301, 302, and 316.

Further, section 404(k)(5)(A) authorizes the Secretary to disallow a
deduction under section 404(k)(1) for any dividend that constitutes, in
substance, an evasion of taxation. Pursuant to section 404(k)(5)(A), a
deduction under section 404(k)(1) would be disallowed for payments in
redemption of employer securities used to make distributions to
terminating ESOP participants because such treatment would constitute, in
substance, an evasion of taxation.


HOLDING

Payments in redemption of stock held by an ESOP that are used to make
distributions to terminating ESOP participants are not deductible. In
addition, such payments do not constitute "applicable dividends" under
section 404(k)(1) of the Internal Revenue Code. This revenue ruling
applies without regard to whether there is appreciation in the employer
securities in the ESOP.


DRAFTING INFORMATION

The principal authors of this revenue ruling are Steven J. Linder of
the Employee Plans, Tax Exempt and Government Entities Division (T:EP) and
John T. Ricotta of the Office of Division Counsel/Associate Chief Counsel
(Tax Exempt and Government Entities). For further information regarding
this revenue ruling, please contact the Employee Plans' taxpayer
assistance telephone service between the hours of 1:30 and 3:30 p.m.
Eastern time, Monday through Thursday, by calling (202) 283-9516. Mr.
Linder's number is (202) 283-9888. Mr. Ricotta's number is (202) 622-6060.
(These telephone numbers are not toll-free.)

<<END RULING>>

TO CONTACT
DON FITCH CPA

Phone Don Fitch CPA Toll Free at (877)CPA-Help or (877)272-4357 or on our Direct Line at (760)674-1722.