Dividends Paid Deduction for Stock Held in Employee Stock Ownership Plan, 51471-51474 [E6-14420]

Download as PDF Federal Register / Vol. 71, No. 168 / Wednesday, August 30, 2006 / Rules and Regulations [FR Doc. E6–14446 Filed 8–29–06; 8:45 am] BILLING CODE 4910–13–P DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1 [TD 9282] RIN 1545–BE74 Dividends Paid Deduction for Stock Held in Employee Stock Ownership Plan Internal Revenue Service (IRS), Treasury. ACTION: Final regulations. AGENCY: jlentini on PROD1PC65 with RULES SUMMARY: This document contains final regulations under sections 162(k) and 404(k) of the Internal Revenue Code (Code) providing that a payment in redemption of employer securities held by an employee stock ownership plan (ESOP) is not deductible. These regulations generally affect administrators of, employers maintaining, participants in, and beneficiaries of ESOPs. In addition, they will affect corporations that make distributions in redemption of stock held in an ESOP. DATES: Effective Date: These regulations are effective on August 30, 2006. Applicability Dates: These regulations apply with respect to payments to reacquire stock that are made on or after and amounts paid or incurred on or after August 30, 2006. See §§ 1.162(k)– 1(c) and 1.404(k)–3, Q&A–2. FOR FURTHER INFORMATION CONTACT: John T. Ricotta at (202) 622–6060 with respect to section 404(k) or Jennifer D. Sledge at (202) 622–7750 with respect to section 162(k) (not toll-free numbers). SUPPLEMENTARY INFORMATION: Background This document contains final regulations (26 CFR part 1) under sections 162(k) and 404(k) of the Code. Section 162(k)(1) generally provides that no deduction otherwise allowable under chapter 1 of the Code is allowed for any amount paid or incurred by a corporation in connection with the reacquisition of its stock or the stock of any related person (as defined in section 465(b)(3)(C)). The legislative history of section 162(k) states that the phrase ‘‘in connection with’’ is ‘‘intended to be construed broadly.’’ H.R. Conf. Rep. No. 99–841, at 168 (1986). Section 404(k)(1) provides a deduction for an applicable dividend paid in cash by a C corporation with VerDate Aug<31>2005 16:32 Aug 29, 2006 Jkt 208001 respect to applicable employer securities held by an ESOP, as defined in section 4975(e)(7). Section 404(k)(2) generally provides that the term applicable dividend means any dividend which, in accordance with the plan provisions, is either paid in cash to plan participants or beneficiaries or paid to the plan and distributed in cash to participants or beneficiaries not later than 90 days after the close of the plan year in which paid. An applicable dividend also includes a dividend which, at the election of participants or their beneficiaries, is payable as provided in the preceding sentence or paid to the plan and reinvested in qualifying employer securities. Finally, an applicable dividend also includes a dividend that is used to make payments on a loan described in section 404(a)(9), the proceeds of which were used to acquire the employer securities (whether or not allocated to participants) with respect to which the dividend is 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 the participant or beneficiary. Prior to 2002, section 404(k)(5)(A) provided that the Secretary may disallow the deduction under section 404(k) for any dividend if the Secretary determines that such dividend constitutes, in substance, an evasion of taxation. Section 662(b) of the Economic Growth and Tax Relief Reconciliation Act of 2001 (115 Stat. 38, 2001) amended section 404(k)(5)(A) to provide that the Secretary may disallow a deduction under section 404(k) for any dividend the Secretary determines constitutes, in substance, an avoidance or evasion of taxation. Rev. Rul. 2001–6 (2001–1 CB 491) (see § 601.601(d)(2) of this chapter), states that distributions to participants of amounts paid by an employer to reacquire shares of its stock from the employer’s ESOP (redemption proceeds) are made in connection with the reacquisition of the employer’s stock and that section 162(k)(1) therefore bars the deduction under these circumstances regardless of whether the distributions to participants would otherwise be deductible under section 404(k). The revenue ruling also states that the treatment of redemption proceeds as ‘‘applicable dividends’’ under section 404(k) would produce such anomalous results that the section cannot reasonably be construed as encompassing such payments. The revenue ruling states that the application of section 404(k) to redemption proceeds not only would PO 00000 Frm 00051 Fmt 4700 Sfmt 4700 51471 allow employers to claim deductions for payments that do not represent true economic costs, but also, as further explained below, would vitiate important rights and protections for recipients of ESOP distributions. Finally, the ruling states that a deduction would be disallowed under section 404(k)(5)(A) because a deduction under these circumstances would constitute, in substance, an evasion of taxation. These positions were reiterated in Notice 2002–2, Q&A–11 (2002–2 CB 285) (See § 601.601(d)(2) of this chapter), which states that, in accordance with Rev. Rul. 2001–6, payments in redemption of stock held by an ESOP that are used to make distributions to terminating ESOP participants constitute an evasion of taxation under section 404(k)(5)(A) and are not applicable dividends under section 404(k)(1). Moreover, the notice states that any deduction for such payments in redemption of stock is barred under section 162(k). Notice 2002–2 (Q&A–7) also discusses the tax treatment of section 404(k) dividend distributions, stating that dividends paid in cash to a participant (rather than reinvested at the option of the participant under section 404(k)(2)(A)(iii)) are taxable without regard to the return of basis provisions under section 72, and are not subject to the consent requirements of section 411(a)(11) or the distribution restrictions of section 401(k)(2)(B). In addition, the Notice provides that dividends paid to participants under section 404(k) are not eligible rollover distributions under section 402(c), even if the dividends are distributed at the same time as amounts that do constitute an eligible rollover distribution (or are reported on Form 1099–R (Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.) in accordance with Announcement 85–168).1 See also § 1.402(c)–2, Q&A–4(e), under which dividends paid on employer securities under section 404(k) are not eligible rollover distributions under section 402(c). In Boise Cascade Corporation v. United States, 329 F.3d 751 (9th Cir. 2003), the Court of Appeals for the Ninth Circuit held that payments made by the issuer of stock to redeem its stock held by its ESOP were deductible as dividends paid under section 404(k), and that the deduction was not 1 Announcement 85–168 (1985–48 IRB 40) states that section 404(k) distributions are reportable as dividends on a recipient’s tax return and that such distributions are fully taxable without regard to return of basis. E:\FR\FM\30AUR1.SGM 30AUR1 jlentini on PROD1PC65 with RULES 51472 Federal Register / Vol. 71, No. 168 / Wednesday, August 30, 2006 / Rules and Regulations precluded by section 162(k). The IRS issued Chief Counsel Notice 2004–038 (October 1, 2004) (available at https:// www.irs.gov/foia through the electronic reading room) to indicate that it disagreed with the Court’s interpretation and would continue to assert in any matter in controversy outside the Ninth Circuit that sections 162(k) and 404(k) disallow a deduction for payments to reacquire employer securities held by an ESOP. For any matter in controversy within the Ninth Circuit, agents or district counsel attorneys are to consult the National Office. A notice of proposed rulemaking containing proposed regulations under sections 162(k) and 404(k) was issued on August 25, 2005 (70 FR 49897) to address two issues: (1) Which corporation is entitled to the deduction for applicable dividends under section 404(k) where the payor and employer are different entities; and (2) whether a payment in redemption of employer securities held by an ESOP is deductible. The issue in the proposed regulations concerning which corporation is entitled to the deduction for applicable dividends under section 404(k) is expected to be addressed in future regulations. The notice of proposed rulemaking included proposed regulations under section 404(k) that would provide that payments made to reacquire stock held by an ESOP are not deductible under section 404(k) because such payments would not constitute applicable dividends under section 404(k)(2) and a deduction for such payments would constitute, in substance, an avoidance or evasion of taxation within the meaning of section 404(k)(5) because it would allow a corporation to claim two deductions for the same economic cost. It also included proposed regulations under section 162(k) providing that section 162(k), subject to certain exceptions, would disallow any deduction for amounts paid or incurred by a corporation in connection with the reacquisition of its stock or the stock of any related person (as defined in section 465(b)(3)(C)). Finally, the proposed regulations provided 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 then distributed by the ESOP to its participants (or their beneficiaries) or otherwise used in a manner described in section 404(k)(2)(A). A public hearing on the proposed regulations was held on January 18, 2006. After consideration of the comments received, these final regulations adopt without material VerDate Aug<31>2005 16:32 Aug 29, 2006 Jkt 208001 change the provisions of the proposed regulations concerning payments in redemption of employer securities held by an ESOP. Explanation of Provisions With respect to the treatment of payments in redemption of employer securities, these final regulations adopt the rule of the proposed regulations under which payments made to reacquire stock held by an ESOP are not deductible under section 404(k) because such payments do not constitute applicable dividends under section 404(k)(2) and a deduction for such payments would constitute, in substance, an avoidance or evasion of taxation within the meaning of section 404(k)(5). These final regulations also adopt the rule of the proposed regulations that explicitly provides that section 162(k) disallows any deduction, including any deduction under section 404(k), for amounts paid or incurred by a corporation in connection with the reacquisition of its stock or the stock of any related person (as defined in section 465(b)(3)(C)). In addition, these final regulations adopt the rule of the proposed regulations providing 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 then distributed by the ESOP to its participants (or their beneficiaries) or otherwise used in a manner described in section 404(k)(2)(A). These provisions aroused little opposition and only two comments were received regarding the treatment of payments made to reacquire stock. A trade association representing companies that sponsor ESOPs supported the position of the proposed regulations that a repurchase of shares of ESOP stock from ESOP participants in a stock redemption does not qualify as a deductible dividend under section 404(k). The other commentator disagreed with the position in the proposed regulations, arguing that redemptions of stock held by an ESOP that are recharacterized as dividends under section 302 nevertheless are proper dividends that should be treated the same as ordinary dividends paid with respect to stock held by an ESOP. The commentator argued that, by enacting section 404(k), Congress intended to allow a double deduction for contributions to purchase employer stock because the value of stock purchased with employer contributions includes the present value of expected future dividends. Thus, the commentator argued, a deduction for PO 00000 Frm 00052 Fmt 4700 Sfmt 4700 redemptive proceeds should not be characterized as an avoidance or evasion of taxation within the meaning of section 404(k)(5). Finally, the commentator argued that, because the legislative history to section 162(k) does not specifically refer to section 404(k) dividends and section 162 was enacted only two years after section 404(k), section 162(k) does not preclude a deduction for a redemptive dividend under section 404(k). These arguments are unpersuasive. Although the present value of expected future dividends is an element of the value of shares of stock at any point in time, and Congress did authorize a current deduction for the value of stock contributions to qualified plans, as well as a later deduction for certain dividends paid on those shares under section 404(k), these deductions are carefully limited to dividends actually paid in certain specified ways while the stock is held by the ESOP. There is no evidence that Congress intended to authorize yet another deduction for the full value of the shares upon their redemption. To allow a deduction for redemption proceeds would be to allow a second deduction that includes the present value of dividends that are paid out after the date of distribution from the ESOP, contrary to the intent of the statute. Moreover, the amount of the deduction with respect to a redemption could be many times the amount that would be deducted for that year for a conventional dividend. (In fact, permitting a second deduction for the full value of the shares would allow a corporation to claim one deduction for a share of stock contributed to an ESOP and allocated to an employee early in a tax year and another deduction if the share is redeemed to make a distribution to the employee later in the same tax year.) There is a no indication that such a result was intended and there is no obvious purpose that would be served by such a result. Congress recognized that an arrangement that might be argued to come within the literal language of section 404(k) might nevertheless be inconsistent with its purpose. Congress therefore granted authority to the Secretary, in section 404(k)(5)(A), to disallow a deduction for any dividend that the Secretary finds to be, in substance, an evasion of taxation. The statute was clarified, for years beginning in 2002, to explicitly broaden that authority to permit the Service to disallow any deduction that is an avoidance or evasion of taxation. A deduction for redemption proceeds is both excessive in amount and inconsistent with the purpose of section E:\FR\FM\30AUR1.SGM 30AUR1 Federal Register / Vol. 71, No. 168 / Wednesday, August 30, 2006 / Rules and Regulations jlentini on PROD1PC65 with RULES 404(k), so that this is clearly an appropriate case for the authority under section 404(k)(5)(A) to be exercised.2 The IRS and Treasury Department also continue to believe, as provided in Rev. Rul. 2001–6, that a deduction for redemption of benefit distributions is appropriately disallowed under section 404(k)(5)(A) because a deduction under these circumstances would constitute, in substance, an evasion of taxation. As stated in Rev. Rul. 2001–6, the treatment of redemption proceeds as ‘‘applicable dividends’’ under section 404(k) would produce such anomalous results that the section cannot reasonably be construed as encompassing such payments. As one example, if a redemption of a benefit distribution were an applicable dividend under section 404(k), there would be no reason why such a redemption could only occur once with respect to a participant, so that multiple redemptions (or theoretically even an unlimited number of redemptions) 3 might be possible, a result that is clearly not consistent with the intent of section 404(k). Further, as described in Rev. Rul. 2001–6, the application of section 404(k) to redemption amounts also would vitiate important rights and protections for recipients of ESOP distributions. These important rights and protections include the right to apply the return of basis provisions under section 72 (whereas an applicable dividend under section 404(k) is includible in gross income without regard to return of basis under section 72), and the protection against involuntary cash-outs (section 411(a)(11)). See section 72(e)(5)(D), and Q&A–7 of Notice 2002–2, 2002–1 CB 285. Similarly, if redemption amounts distributed as a normal benefit distribution were treated as an applicable dividend under section 404(k), then a participant would not have the right to elect a direct or indirect rollover with respect to redemption proceeds that are distributed from the ESOP, and any notice provided to the employee as required by section 402(f) would have to 2 Given the special rules of section 409(h) which generally entitle participants to receive cash for employer securities that are not publicly traded, if Congress had so intended, it would likely have identified the interaction of these provisions in light of the potentially large additional deductions such a rule would permit. Cf., Charles Ilfeld Co. v. Hernandez, 292 U.S. 62 (1934). 3 For example, a plan participant might elect to have his or her account balance redeemed to the extent invested in employer securities, and then promptly have the cash reinvested in employer securities, and then could immediately repeat this redemption/reinvestment process with no theoretical limit. VerDate Aug<31>2005 16:32 Aug 29, 2006 Jkt 208001 identify the loss of this valuable right to the participant. See § 1.402(c)–2, Q&A– 4(e). Congress also provided for other special treatment for applicable dividends under section 404(k) that would be inconsistent with redemption of a normal benefit distribution being treated as an applicable dividend under section 404(k). Section 72(t)(2)(A)(vi) provides for an exception to the 10 percent additional income tax for early distributions for dividends paid with respect to stock of a corporation which are described in section 404(k). Further, section 404(k)(5)(B) provides that a plan will not violate the requirements of sections 401, 409, or 4975(e)(7) or be engaging in a prohibited transaction merely by reason of distributing an applicable dividend under section 404(k). Thus, for example, a distribution of an applicable dividend under section 404(k) is not subject to the prohibition against in-service distributions of amounts attributable to elective deferrals under section 401(k)(2). Clearly, these broad exceptions under section 72(t)(2)(A)(vi) and 404(k)(5)(B) were not intended to apply to normal benefit distributions from ESOPs, essentially at the election of the employer or distributee. Finally, even if the IRS declined to exercise its authority under section 404(k)(5)(A), the plain language of section 162(k) precludes the deduction for payments by a corporation to redeem its stock including deductions otherwise allowed under section 404(k). As described under the Background section of this preamble, section 162(k) provides that ‘‘no deduction otherwise allowable shall be allowed under this chapter for any amount paid or incurred by a corporation in connection with the reacquisition of its stock’’ (emphasis added) and section 404(k) is in the same chapter as section 162(k). The commentator’s attempt to avoid the effect of the plain language of the statute by reference to a supposed negative inference in the legislative history is unavailing. Accordingly, these regulations adopt the rule in the proposed regulations without material change. Effective Date Section 1.162(k)–1 applies with respect to amounts paid or incurred on or after August 30, 2006. Section 1.404(k)–3 applies with respect to payments to reacquire stock that are made on or after August 30, 2006. Rev. Rul. 2001–6 remains in effect for all periods, including periods before the effective date of this regulation. PO 00000 Frm 00053 Fmt 4700 Sfmt 4700 51473 Special Analyses It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the proposed regulations preceding these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. Drafting Information The principal authors of these regulations are John T. Ricotta, Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities) and Jennifer D. Sledge, Office of Associate Chief Counsel (Corporate). However, other personnel from the IRS and the Treasury Department participated in the development of these regulations. List of Subjects in 26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1 is amended as follows: I PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 is amended by adding entries in numerical order to read as follows: I Authority: 26 U.S.C. 7805 * * * Section 1.162(k)–1 is also issued under section 26 U.S.C. 162(k). * * * Section 1.404(k)–3 is also issued under sections 26 U.S.C. 162(k) and 404(k)(5)(A). * * * I Par. 2. Section 1.162(k)–1 is added to read as follows: § 1.162(k)–1 Disallowance of deduction for reacquisition payments. (a) In general. Except as provided in paragraph (b) of this section, no deduction otherwise allowable is allowed under Chapter 1 of the Internal Revenue Code for any amount paid or incurred by a corporation in connection with the reacquisition of its stock or the stock of any related person (as defined in section 465(b)(3)(C)). Amounts paid or incurred in connection with the E:\FR\FM\30AUR1.SGM 30AUR1 51474 Federal Register / Vol. 71, No. 168 / Wednesday, August 30, 2006 / Rules and Regulations 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). See § 1.404(k)–3. (b) Exceptions. Paragraph (a) of this section does not apply to any— (1) Deduction allowable under section 163 (relating to interest); (2) Deduction for amounts that are properly allocable to indebtedness and amortized over the term of such indebtedness; (3) Deduction for dividends paid (within the meaning of section 561); or (4) Amount paid or incurred in connection with the redemption of any stock in a regulated investment company that issues only stock which is redeemable upon the demand of the shareholder. (c) Effective date. This section applies with respect to amounts paid or incurred on or after August 30, 2006. I Par. 3. Section 1.404(k)–3 is added to read as follows: § 1.404(k)–3 Disallowance of deduction for reacquisition payments. jlentini on PROD1PC65 with RULES Q–1: Are payments to reacquire stock held by an ESOP applicable dividends that are deductible under section 404(k)(1)? A–1: (a) Payments to reacquire stock held by an ESOP, including reacquisition payments that are used to make benefit distributions to participants or beneficiaries, are not deductible under section 404(k) because— (1) Those payments do not constitute applicable dividends under section 404(k)(2); and (2) The treatment of those payments as applicable dividends would constitute, in substance, an avoidance or evasion of taxation within the meaning of section 404(k)(5). (b) See also § 1.162(k)–1 concerning the disallowance of deductions for amounts paid or incurred by a corporation in connection with the reacquisition of its stock from an ESOP. Q–2: What is the effective date of this section? A–2: This section applies with respect to payments to reacquire stock that are made on or after August 30, 2006. Approved: August 22, 2006. Mark E. Matthews, Deputy Commissioner for Services and Enforcement. Eric Solomon, Acting Deputy Assistant Secretary of the Treasury (Tax Policy). [FR Doc. E6–14420 Filed 8–29–06; 8:45 am] BILLING CODE 4830–01–P VerDate Aug<31>2005 16:32 Aug 29, 2006 Jkt 208001 DEPARTMENT OF DEFENSE Office of the Secretary 32 CFR Part 154 [DoD–2006–OS–0038] Department of Defense Personnel Security Program Regulation Office of the Secretary, DoD. Interim final rule. AGENCY: ACTION: This rule is published to streamline personnel security clearance procedures and make the process more efficient within the Department of Defense. This will simplify security processing and allow the deserving public to obtain a security clearance in a more efficient manner. DATES: This rule is effective September 1, 2006. Written comments received at the address indicated below by October 30, 2006 will be accepted. ADDRESSES: You may submit comments, identified by docket number and or RIN number and title, by any of the following methods: • Federal eRulemaking Portal: https:// www.regulations.gov. Follow the instructions for submitting comments. • Mail: Federal Docket Management System Office, 1160 Defense Pentagon, Washington, DC 20301–1160. Instructions: All submissions received must include the agency name and docket number or Regulatory Information Number (RIN) for this Federal Register document. The general policy for comments and other submissions from members of the public is to make these submissions available for public viewing on the Internet at https://regulations.gov as they are received without change, including any personal identifiers or contact information. FOR FURTHER INFORMATION CONTACT: Charleen Wright, 703–697–3039. SUPPLEMENTARY INFORMATION: This rule is published as an interim rule because it takes effect on September 1 under the authority of National Security Adviser directing immediate implementation. SUMMARY: Executive Order 12866, ‘‘Regulatory Planning and Review’’ It has been determined that 32 CFR part 154 is not a significant regulatory action. The rule does not: (1) Have an annual effect on the economy of $100 million or more or adversely affect in a material way the economy; a section of the economy; productivity; competition; jobs; the environment; public health or safety; or State, local, or tribal governments or communities; PO 00000 Frm 00054 Fmt 4700 Sfmt 4700 (2) Create a serious inconsistency or otherwise interfere with an action taken or planned by another Agency; (3) Materially alter the budgetary impact of entitlements, grants, user fees, or loan programs, or the rights and obligations of recipients thereof; or (4) Raise novel legal or policy issues arising out of legal mandates, the President’s priorities, or the principles set forth in this Executive Order. Unfunded Mandates Reform Act (Sec. 202, Pub. L. 104–4) It has been certified that this rule does not contain a Federal mandate that may result in the expenditure by State, local and tribal governments, in aggregate, or by the private sector, of $100 million or more in any one year. Public Law 96–354, ‘‘Regulatory Flexibility Act’’ (5 U.S.C. 601) It has been certified that this rule is not subject to the Regulatory Flexibility Act (5 U.S.C. 601) because it would not, if promulgated, have a significant economic impact on a substantial number of small entities. This part will streamline personnel security clearance procedures and make the process more efficient. Public Law 96–511, ‘‘Paperwork Reduction Act’’ (44 U.S.C. Chapter 35) It has been certified that this rule does impose reporting or recordkeeping requirements under the Paperwork Reduction Act of 1995. The reporting and recordkeeping requirements have been submitted to OMB for review. Executive Order 13132, ‘‘Federalism’’ It has been certified that this rule does not have federalism implications, as set forth in Executive Order 13132. This rule does not have substantial direct effects on: (1) The States; (2) The relationship between the National Government and the States; or (3) The distribution of power and responsibilities among the various levels of Government. List of Subjects in 32 CFR Part 154 Classified information; Government employees; Investigations; Security measures. I Accordingly, 32 CFR part 154 is amended as follows: PART 154—DEPARTMENT OF DEFENSE PERSONNEL SECURITY PROGRAM REGULATION 1. The authority citation for 32 CFR part 154 continues to read as follows: I Authority: E.O. 10450, 18 FR 2489, 3 CFR, 1949–1953 Comp., p. 936; E.O. 12356, 47 FR E:\FR\FM\30AUR1.SGM 30AUR1

Agencies

[Federal Register Volume 71, Number 168 (Wednesday, August 30, 2006)]
[Rules and Regulations]
[Pages 51471-51474]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E6-14420]


=======================================================================
-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9282]
RIN 1545-BE74


Dividends Paid Deduction for Stock Held in Employee Stock 
Ownership Plan

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final regulations under sections 162(k) 
and 404(k) of the Internal Revenue Code (Code) providing that a payment 
in redemption of employer securities held by an employee stock 
ownership plan (ESOP) is not deductible. These regulations generally 
affect administrators of, employers maintaining, participants in, and 
beneficiaries of ESOPs. In addition, they will affect corporations that 
make distributions in redemption of stock held in an ESOP.

DATES: Effective Date: These regulations are effective on August 30, 
2006.
    Applicability Dates: These regulations apply with respect to 
payments to reacquire stock that are made on or after and amounts paid 
or incurred on or after August 30, 2006. See Sec. Sec.  1.162(k)-1(c) 
and 1.404(k)-3, Q&A-2.

FOR FURTHER INFORMATION CONTACT: John T. Ricotta at (202) 622-6060 with 
respect to section 404(k) or Jennifer D. Sledge at (202) 622-7750 with 
respect to section 162(k) (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document contains final regulations (26 CFR part 1) under 
sections 162(k) and 404(k) of the Code.
    Section 162(k)(1) generally provides that no deduction otherwise 
allowable under chapter 1 of the Code is allowed for any amount paid or 
incurred by a corporation in connection with the reacquisition of its 
stock or the stock of any related person (as defined in section 
465(b)(3)(C)). The legislative history of section 162(k) states that 
the phrase ``in connection with'' is ``intended to be construed 
broadly.'' H.R. Conf. Rep. No. 99-841, at 168 (1986).
    Section 404(k)(1) provides a deduction for an applicable dividend 
paid in cash by a C corporation with respect to applicable employer 
securities held by an ESOP, as defined in section 4975(e)(7). Section 
404(k)(2) generally provides that the term applicable dividend means 
any dividend which, in accordance with the plan provisions, is either 
paid in cash to plan participants or beneficiaries or paid to the plan 
and distributed in cash to participants or beneficiaries not later than 
90 days after the close of the plan year in which paid. An applicable 
dividend also includes a dividend which, at the election of 
participants or their beneficiaries, is payable as provided in the 
preceding sentence or paid to the plan and reinvested in qualifying 
employer securities. Finally, an applicable dividend also includes a 
dividend that is used to make payments on a loan described in section 
404(a)(9), the proceeds of which were used to acquire the employer 
securities (whether or not allocated to participants) with respect to 
which the dividend is 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 the participant or beneficiary.
    Prior to 2002, section 404(k)(5)(A) provided that the Secretary may 
disallow the deduction under section 404(k) for any dividend if the 
Secretary determines that such dividend constitutes, in substance, an 
evasion of taxation. Section 662(b) of the Economic Growth and Tax 
Relief Reconciliation Act of 2001 (115 Stat. 38, 2001) amended section 
404(k)(5)(A) to provide that the Secretary may disallow a deduction 
under section 404(k) for any dividend the Secretary determines 
constitutes, in substance, an avoidance or evasion of taxation.
    Rev. Rul. 2001-6 (2001-1 CB 491) (see Sec.  601.601(d)(2) of this 
chapter), states that distributions to participants of amounts paid by 
an employer to reacquire shares of its stock from the employer's ESOP 
(redemption proceeds) are made in connection with the reacquisition of 
the employer's stock and that section 162(k)(1) therefore bars the 
deduction under these circumstances regardless of whether the 
distributions to participants would otherwise be deductible under 
section 404(k). The revenue ruling also states that the treatment of 
redemption proceeds as ``applicable dividends'' under section 404(k) 
would produce such anomalous results that the section cannot reasonably 
be construed as encompassing such payments. The revenue ruling states 
that the application of section 404(k) to redemption proceeds not only 
would allow employers to claim deductions for payments that do not 
represent true economic costs, but also, as further explained below, 
would vitiate important rights and protections for recipients of ESOP 
distributions. Finally, the ruling states that a deduction would be 
disallowed under section 404(k)(5)(A) because a deduction under these 
circumstances would constitute, in substance, an evasion of taxation.
    These positions were reiterated in Notice 2002-2, Q&A-11 (2002-2 CB 
285) (See Sec.  601.601(d)(2) of this chapter), which states that, in 
accordance with Rev. Rul. 2001-6, payments in redemption of stock held 
by an ESOP that are used to make distributions to terminating ESOP 
participants constitute an evasion of taxation under section 
404(k)(5)(A) and are not applicable dividends under section 404(k)(1). 
Moreover, the notice states that any deduction for such payments in 
redemption of stock is barred under section 162(k).
    Notice 2002-2 (Q&A-7) also discusses the tax treatment of section 
404(k) dividend distributions, stating that dividends paid in cash to a 
participant (rather than reinvested at the option of the participant 
under section 404(k)(2)(A)(iii)) are taxable without regard to the 
return of basis provisions under section 72, and are not subject to the 
consent requirements of section 411(a)(11) or the distribution 
restrictions of section 401(k)(2)(B). In addition, the Notice provides 
that dividends paid to participants under section 404(k) are not 
eligible rollover distributions under section 402(c), even if the 
dividends are distributed at the same time as amounts that do 
constitute an eligible rollover distribution (or are reported on Form 
1099-R (Distributions From Pensions, Annuities, Retirement or Profit-
Sharing Plans, IRAs, Insurance Contracts, etc.) in accordance with 
Announcement 85-168).\1\ See also Sec.  1.402(c)-2, Q&A-4(e), under 
which dividends paid on employer securities under section 404(k) are 
not eligible rollover distributions under section 402(c).
---------------------------------------------------------------------------

    \1\ Announcement 85-168 (1985-48 IRB 40) states that section 
404(k) distributions are reportable as dividends on a recipient's 
tax return and that such distributions are fully taxable without 
regard to return of basis.
---------------------------------------------------------------------------

    In Boise Cascade Corporation v. United States, 329 F.3d 751 (9th 
Cir. 2003), the Court of Appeals for the Ninth Circuit held that 
payments made by the issuer of stock to redeem its stock held by its 
ESOP were deductible as dividends paid under section 404(k), and that 
the deduction was not

[[Page 51472]]

precluded by section 162(k). The IRS issued Chief Counsel Notice 2004-
038 (October 1, 2004) (available at https://www.irs.gov/foia through the 
electronic reading room) to indicate that it disagreed with the Court's 
interpretation and would continue to assert in any matter in 
controversy outside the Ninth Circuit that sections 162(k) and 404(k) 
disallow a deduction for payments to reacquire employer securities held 
by an ESOP. For any matter in controversy within the Ninth Circuit, 
agents or district counsel attorneys are to consult the National 
Office.
    A notice of proposed rulemaking containing proposed regulations 
under sections 162(k) and 404(k) was issued on August 25, 2005 (70 FR 
49897) to address two issues: (1) Which corporation is entitled to the 
deduction for applicable dividends under section 404(k) where the payor 
and employer are different entities; and (2) whether a payment in 
redemption of employer securities held by an ESOP is deductible. The 
issue in the proposed regulations concerning which corporation is 
entitled to the deduction for applicable dividends under section 404(k) 
is expected to be addressed in future regulations.
    The notice of proposed rulemaking included proposed regulations 
under section 404(k) that would provide that payments made to reacquire 
stock held by an ESOP are not deductible under section 404(k) because 
such payments would not constitute applicable dividends under section 
404(k)(2) and a deduction for such payments would constitute, in 
substance, an avoidance or evasion of taxation within the meaning of 
section 404(k)(5) because it would allow a corporation to claim two 
deductions for the same economic cost. It also included proposed 
regulations under section 162(k) providing that section 162(k), subject 
to certain exceptions, would disallow any deduction for amounts paid or 
incurred by a corporation in connection with the reacquisition of its 
stock or the stock of any related person (as defined in section 
465(b)(3)(C)). Finally, the proposed regulations provided 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 then distributed by the ESOP to its participants (or their 
beneficiaries) or otherwise used in a manner described in section 
404(k)(2)(A).
    A public hearing on the proposed regulations was held on January 
18, 2006. After consideration of the comments received, these final 
regulations adopt without material change the provisions of the 
proposed regulations concerning payments in redemption of employer 
securities held by an ESOP.

Explanation of Provisions

    With respect to the treatment of payments in redemption of employer 
securities, these final regulations adopt the rule of the proposed 
regulations under which payments made to reacquire stock held by an 
ESOP are not deductible under section 404(k) because such payments do 
not constitute applicable dividends under section 404(k)(2) and a 
deduction for such payments would constitute, in substance, an 
avoidance or evasion of taxation within the meaning of section 
404(k)(5). These final regulations also adopt the rule of the proposed 
regulations that explicitly provides that section 162(k) disallows any 
deduction, including any deduction under section 404(k), for amounts 
paid or incurred by a corporation in connection with the reacquisition 
of its stock or the stock of any related person (as defined in section 
465(b)(3)(C)). In addition, these final regulations adopt the rule of 
the proposed regulations providing 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 then 
distributed by the ESOP to its participants (or their beneficiaries) or 
otherwise used in a manner described in section 404(k)(2)(A).
    These provisions aroused little opposition and only two comments 
were received regarding the treatment of payments made to reacquire 
stock. A trade association representing companies that sponsor ESOPs 
supported the position of the proposed regulations that a repurchase of 
shares of ESOP stock from ESOP participants in a stock redemption does 
not qualify as a deductible dividend under section 404(k).
    The other commentator disagreed with the position in the proposed 
regulations, arguing that redemptions of stock held by an ESOP that are 
recharacterized as dividends under section 302 nevertheless are proper 
dividends that should be treated the same as ordinary dividends paid 
with respect to stock held by an ESOP. The commentator argued that, by 
enacting section 404(k), Congress intended to allow a double deduction 
for contributions to purchase employer stock because the value of stock 
purchased with employer contributions includes the present value of 
expected future dividends. Thus, the commentator argued, a deduction 
for redemptive proceeds should not be characterized as an avoidance or 
evasion of taxation within the meaning of section 404(k)(5). Finally, 
the commentator argued that, because the legislative history to section 
162(k) does not specifically refer to section 404(k) dividends and 
section 162 was enacted only two years after section 404(k), section 
162(k) does not preclude a deduction for a redemptive dividend under 
section 404(k).
    These arguments are unpersuasive. Although the present value of 
expected future dividends is an element of the value of shares of stock 
at any point in time, and Congress did authorize a current deduction 
for the value of stock contributions to qualified plans, as well as a 
later deduction for certain dividends paid on those shares under 
section 404(k), these deductions are carefully limited to dividends 
actually paid in certain specified ways while the stock is held by the 
ESOP. There is no evidence that Congress intended to authorize yet 
another deduction for the full value of the shares upon their 
redemption. To allow a deduction for redemption proceeds would be to 
allow a second deduction that includes the present value of dividends 
that are paid out after the date of distribution from the ESOP, 
contrary to the intent of the statute. Moreover, the amount of the 
deduction with respect to a redemption could be many times the amount 
that would be deducted for that year for a conventional dividend. (In 
fact, permitting a second deduction for the full value of the shares 
would allow a corporation to claim one deduction for a share of stock 
contributed to an ESOP and allocated to an employee early in a tax year 
and another deduction if the share is redeemed to make a distribution 
to the employee later in the same tax year.) There is a no indication 
that such a result was intended and there is no obvious purpose that 
would be served by such a result.
    Congress recognized that an arrangement that might be argued to 
come within the literal language of section 404(k) might nevertheless 
be inconsistent with its purpose. Congress therefore granted authority 
to the Secretary, in section 404(k)(5)(A), to disallow a deduction for 
any dividend that the Secretary finds to be, in substance, an evasion 
of taxation. The statute was clarified, for years beginning in 2002, to 
explicitly broaden that authority to permit the Service to disallow any 
deduction that is an avoidance or evasion of taxation. A deduction for 
redemption proceeds is both excessive in amount and inconsistent with 
the purpose of section

[[Page 51473]]

404(k), so that this is clearly an appropriate case for the authority 
under section 404(k)(5)(A) to be exercised.\2\
---------------------------------------------------------------------------

    \2\ Given the special rules of section 409(h) which generally 
entitle participants to receive cash for employer securities that 
are not publicly traded, if Congress had so intended, it would 
likely have identified the interaction of these provisions in light 
of the potentially large additional deductions such a rule would 
permit. Cf., Charles Ilfeld Co. v. Hernandez, 292 U.S. 62 (1934).
---------------------------------------------------------------------------

    The IRS and Treasury Department also continue to believe, as 
provided in Rev. Rul. 2001-6, that a deduction for redemption of 
benefit distributions is appropriately disallowed under section 
404(k)(5)(A) because a deduction under these circumstances would 
constitute, in substance, an evasion of taxation. As stated in Rev. 
Rul. 2001-6, the treatment of redemption proceeds as ``applicable 
dividends'' under section 404(k) would produce such anomalous results 
that the section cannot reasonably be construed as encompassing such 
payments. As one example, if a redemption of a benefit distribution 
were an applicable dividend under section 404(k), there would be no 
reason why such a redemption could only occur once with respect to a 
participant, so that multiple redemptions (or theoretically even an 
unlimited number of redemptions) \3\ might be possible, a result that 
is clearly not consistent with the intent of section 404(k).
---------------------------------------------------------------------------

    \3\ For example, a plan participant might elect to have his or 
her account balance redeemed to the extent invested in employer 
securities, and then promptly have the cash reinvested in employer 
securities, and then could immediately repeat this redemption/
reinvestment process with no theoretical limit.
---------------------------------------------------------------------------

    Further, as described in Rev. Rul. 2001-6, the application of 
section 404(k) to redemption amounts also would vitiate important 
rights and protections for recipients of ESOP distributions. These 
important rights and protections include the right to apply the return 
of basis provisions under section 72 (whereas an applicable dividend 
under section 404(k) is includible in gross income without regard to 
return of basis under section 72), and the protection against 
involuntary cash-outs (section 411(a)(11)). See section 72(e)(5)(D), 
and Q&A-7 of Notice 2002-2, 2002-1 CB 285. Similarly, if redemption 
amounts distributed as a normal benefit distribution were treated as an 
applicable dividend under section 404(k), then a participant would not 
have the right to elect a direct or indirect rollover with respect to 
redemption proceeds that are distributed from the ESOP, and any notice 
provided to the employee as required by section 402(f) would have to 
identify the loss of this valuable right to the participant. See Sec.  
1.402(c)-2, Q&A-4(e).
    Congress also provided for other special treatment for applicable 
dividends under section 404(k) that would be inconsistent with 
redemption of a normal benefit distribution being treated as an 
applicable dividend under section 404(k). Section 72(t)(2)(A)(vi) 
provides for an exception to the 10 percent additional income tax for 
early distributions for dividends paid with respect to stock of a 
corporation which are described in section 404(k). Further, section 
404(k)(5)(B) provides that a plan will not violate the requirements of 
sections 401, 409, or 4975(e)(7) or be engaging in a prohibited 
transaction merely by reason of distributing an applicable dividend 
under section 404(k). Thus, for example, a distribution of an 
applicable dividend under section 404(k) is not subject to the 
prohibition against in-service distributions of amounts attributable to 
elective deferrals under section 401(k)(2). Clearly, these broad 
exceptions under section 72(t)(2)(A)(vi) and 404(k)(5)(B) were not 
intended to apply to normal benefit distributions from ESOPs, 
essentially at the election of the employer or distributee.
    Finally, even if the IRS declined to exercise its authority under 
section 404(k)(5)(A), the plain language of section 162(k) precludes 
the deduction for payments by a corporation to redeem its stock 
including deductions otherwise allowed under section 404(k). As 
described under the Background section of this preamble, section 162(k) 
provides that ``no deduction otherwise allowable shall be allowed under 
this chapter for any amount paid or incurred by a corporation in 
connection with the reacquisition of its stock'' (emphasis added) and 
section 404(k) is in the same chapter as section 162(k). The 
commentator's attempt to avoid the effect of the plain language of the 
statute by reference to a supposed negative inference in the 
legislative history is unavailing.
    Accordingly, these regulations adopt the rule in the proposed 
regulations without material change.

Effective Date

    Section 1.162(k)-1 applies with respect to amounts paid or incurred 
on or after August 30, 2006.
    Section 1.404(k)-3 applies with respect to payments to reacquire 
stock that are made on or after August 30, 2006. Rev. Rul. 2001-6 
remains in effect for all periods, including periods before the 
effective date of this regulation.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations, and because the 
regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, the proposed 
regulations preceding these regulations were submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Drafting Information

    The principal authors of these regulations are John T. Ricotta, 
Office of Division Counsel/Associate Chief Counsel (Tax Exempt and 
Government Entities) and Jennifer D. Sledge, Office of Associate Chief 
Counsel (Corporate). However, other personnel from the IRS and the 
Treasury Department participated in the development of these 
regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.162(k)-1 is also issued under section 26 U.S.C. 162(k). * 
* *
    Section 1.404(k)-3 is also issued under sections 26 U.S.C. 162(k) 
and 404(k)(5)(A). * * *

0
Par. 2. Section 1.162(k)-1 is added to read as follows:


Sec.  1.162(k)-1  Disallowance of deduction for reacquisition payments.

    (a) In general. Except as provided in paragraph (b) of this 
section, no deduction otherwise allowable is allowed under Chapter 1 of 
the Internal Revenue Code for any amount paid or incurred by a 
corporation in connection with the reacquisition of its stock or the 
stock of any related person (as defined in section 465(b)(3)(C)). 
Amounts paid or incurred in connection with the

[[Page 51474]]

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). See Sec.  1.404(k)-3.
    (b) Exceptions. Paragraph (a) of this section does not apply to 
any--
    (1) Deduction allowable under section 163 (relating to interest);
    (2) Deduction for amounts that are properly allocable to 
indebtedness and amortized over the term of such indebtedness;
    (3) Deduction for dividends paid (within the meaning of section 
561); or
    (4) Amount paid or incurred in connection with the redemption of 
any stock in a regulated investment company that issues only stock 
which is redeemable upon the demand of the shareholder.
    (c) Effective date. This section applies with respect to amounts 
paid or incurred on or after August 30, 2006.

0
Par. 3. Section 1.404(k)-3 is added to read as follows:


Sec.  1.404(k)-3  Disallowance of deduction for reacquisition payments.

    Q-1: Are payments to reacquire stock held by an ESOP applicable 
dividends that are deductible under section 404(k)(1)?
    A-1: (a) Payments to reacquire stock held by an ESOP, including 
reacquisition payments that are used to make benefit distributions to 
participants or beneficiaries, are not deductible under section 404(k) 
because--
    (1) Those payments do not constitute applicable dividends under 
section 404(k)(2); and
    (2) The treatment of those payments as applicable dividends would 
constitute, in substance, an avoidance or evasion of taxation within 
the meaning of section 404(k)(5).
    (b) See also Sec.  1.162(k)-1 concerning the disallowance of 
deductions for amounts paid or incurred by a corporation in connection 
with the reacquisition of its stock from an ESOP.
    Q-2: What is the effective date of this section?
    A-2: This section applies with respect to payments to reacquire 
stock that are made on or after August 30, 2006.

    Approved: August 22, 2006.
Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. E6-14420 Filed 8-29-06; 8:45 am]
BILLING CODE 4830-01-P

This site is protected by reCAPTCHA and the Google Privacy Policy and Terms of Service apply.