IRS Issues Final Rules on Deductions for Repurchase of ESOP Shares

On August 30th, the IRS published final regulations disallowing deductions for the repurchase of ESOP shares (26 CFR, Part 1, TD 9282). The regulations were necessitated because of a Ninth Circuit Court of Appeals decision (Boise Cascade Corporation v. United States) in which Boise Cascade successfully argued that the repurchase of stock from departing ESOP participants was deductible under Section 404(k) of the Code, which allows deductions for dividends paid to ESOP participants. This novel argument was rejected by virtually the entire ESOP legal community as "double dipping" for the corporate deduction and potentially harmful to participants, who now would have to treat their distributions as taxable dividends.

The IRS issued field directives to disallow such deductions, and now has issued final regulations on the matter, effective August 30, 2006. Specifically, the regulations state that 404(k) does not apply in this case and that the reacquisition of stock falls under Section 162(k) of the Code (which generally disallows deductions for any corporate reacquisition of shares). The regulations apply to any stock reacquired on or after August 30, 2006. Meanwhile, a previous IRS ruling (Rev. Rul. 2001-6), which also barred such deductions, remains in effect except in the Ninth Circuit. The IRS advised agents in that circuit to contact the IRS national office if any cases come up in which a company tries to claim deductions (none have, as far as we know).