Court: Trustees Own ESOP Shares, Entitled to Tax Deduction

May 22, 2003 ( - The trustee of the employee stock ownership plan (ESOP) is the owner of the stock and therefore, payments made by a company for stock redemption are deductible as dividends paid pursuant to tax code Section 404(k).

>The 9th US Circuit Court of Appeals made the determination that the plan participants were not the owners of the stock when the redemptions took place, since the terms of the certificate of designation for the convertible preferred stock in question stated that such stock could only be issued to the trustees.   “It was literally impossible for the Participants to own the convertible preferred stock,” Circuit Judge Sidney Thomas said writing for the court, according to Washington-based legal publisher BNA.

>With the ruling, the court rejected the government’s argument that the participants were the beneficial owners because they had the right to instruct the trustee in how to vote their share of the convertible preferred stock and the right to instruct the trustee on how to respond to tender offers for the stock.   No person may be treated as the owner of a trust based solely on the amount of control that person exercises over the trust, the court said.

>Additionally, the trust held legal title at the time of redemption and could sell or convert the convertible preferred stock and receive dividends paid with respect to the stock. Conversely, participants had extremely limited rights, evidenced by the plan’s trustees overriding the participants’ rights on one occasion concerning a tender offer when the trustee determined that following the instructions would violate ERISA, the court noted.

Deduction Dividend

>Boise Cascade Corp. added an ESOP to its employee Savings and Supplement Retirement Plan, establishing a trust to hold and invest assets accumulated under the retirement plan. On July 10, 1989, Boise Cascade’s board of directors adopted a resolution creating a new series of convertible preferred stock consisting of 6,745,347 shares that would only be issued to, and held by, the trustee.

>Under the terms of the plan, if the stock were transferred to any person other than the trustee, it would convert automatically into shares of Boise Cascade common stock.   Further, upon a plan participant’s termination of employment for any reason, convertible preferred stock equal in value to the participant’s vested account balance in the ESOP fund was redeemed, regardless of any election by the participant with respect to the disposition of the vested account balances. At Boise Cascade’s election, redemption payments could be made in either cash or in common stock. All redemption payments in 1989 were in cash.

>Toward the end of 1989, the board of directors declared a dividend on the convertible preferred.   On December 28, 1989, a dividend of $11,192,244.47 was paid to the trustee and applied to repay the ESOP loans in accordance with the terms of the plan. Pursuant to Section 404(k), Boise Cascade claimed a deduction on its 1989 federal income tax return for the entire amount of the dividend. The Internal Revenue Service (IRS) allowed the deduction.

>The company subsequently filed an amended return for 1989 claiming a refund attributable to the redemption of convertible preferred stock due to employee terminations, however the IRS disallowed this refund.

>Boise Cascade filed a lawsuit in the US District Court for the District of Idaho, contending that the amounts paid in redemption of stock due to employee terminations were also deductible under Section 404(k). The district court granted summary judgment for Boise Cascade.

On Appeal

>The IRS appealed the district court’s decision.   On appeal, the appeals court affirmed the district court’s decision that the redemption qualified as refunds under IRC Section 302(b) and were therefore deductible under Section 404(k).

>The appellate court found Section 404(k) allows a corporation to deduct the amount of certain tax dividends paid by a corporation into an ESOP. To qualify, the dividend must be:

  • paid in cash to the plan participants or their beneficiaries
  • paid to the plan and distributed in cash to participants or their beneficiaries not later than 90 days after the close of the plan year in which paid
  • used to make payments on a loan, the proceeds of which were used to acquire stock held by the ESOP.

>In this case, Boise Cascade’s payments were dividends pursuant to Section 404(k), since the payments were first made to the plan and then distributed to the participants in 1989, the court said. Second, the amounts paid were distributed out of current or accumulated earnings and profits as required under IRC Section 316(a), the court added.

>Under Section 316(a), for the redemption payments to be deductible they must qualify as dividends under IRC Section 301 in relation to IRC Section 302, the court said. To qualify as dividends under the applicable section of 302, the payments must not have resulted “in a meaningful reduction of the shareholder’s proportionate interest in the corporation,” the court added.

A meaningful reduction in proportionate interest would have resulted if the participants were to be treated as the owners of the convertible stock that was redeemed, but not if the trust were treated as the owner. Thus, Boise Cascade’s entitlement to a deduction under Section 404(k) depended on whether the trust or the participants owned the convertible preferred stock when the redemptions took place, the appeals court said.

>Further, applying Section 318(a) to determine ownership, the court said stock owned by a tax code Section 401(a) employees’ trust under a profit sharing plan, such as the ESOP, is not considered owned by its beneficiaries.   Therefore, the trustee, not the participants, owned the convertible preferred stock when the redemption occurred, and a deduction under Section 404(k) was appropriate, the court said.

The case is Boise Cascade Corp. v. U.S., 9th Cir., No. 01-36086, 5/20/03.