No deduction for high-rate dividend used to pay off ESOP loan.

• Author: Elinsky, Peter I.
• Position: Exempt employee stock option plan

The IRS has ruled in Letter Ruling (TAM) 9304003 that a corporation could not deduct an "extraordinary" dividend paid as part of a redemption and used to pay off an exempt employee stock option plan (ESOP) loan. According to the Service, the dividend was not deductible because the dividend rate was not "reasonable"--i.e., not a rate normally paid in the ordinary course of business.

Corporation set up a qualified leveraged ESOP in 1986, using back-to-back loans from Bank to Corporation and then from Corporation to the ESOP. The ESOP used the loan proceeds to buy, at $10 a share, 30% of Corporation's stock from Seller, who had previously owned all of Corporation's stock. After the sale, the ESOP owned 150,000 shares and Seller owned the remaining 350,000. In 1988, the following series of events occurred. * An unrelated corporation bought 35,000 of Seller's 350,000 shares. * Corporation redeemed Seller's remaining 315,000 shares at their current fair market value of $12 a share. * Corporation redeemed 135,000 of the ESOP's 150,000 shares at $12 a share. * The ESOP used part of the redemption proceeds to pay off the exempt loan.

After these transactions, the ESOP continued to own 30% of Corporation, but the number of shares it held was reduced by 90%, from 150,000 shares to 15,000 shares. In a 1991 technical advice memorandum, the IRS had ruled that the redemption proceeds the ESOP received constituted a dividend. Corporation claimed a deduction under Sec. 404(k) for that part of the dividend the ESOP used to pay off the exempt loan.

Sec. 404(k)(2)(A)(iii) allows a deduction for dividends paid on stock held by an ESOP and used to make payments on an ESOP loan. Sec. 404(k)(5)(a) and the Conference Report to the Tax Reform Act of 1986 (in which this...