IRS Says ESOP Redemptions Are Not Deductible; Limits ESOP Deductions for Foreign Companies to Parent Company, Not Subsidiary

On August 25, the IRS published REG-133578-05, proposed regulations that cover two ESOP dividend deduction scenarios. In the first, it said it would not allow companies to deduct the cost of repurchasing shares from departing employees. Boise Cascade had successfully argued that it could treat such redemptions as dividends deductible under Section 404(k) of the Code. The IRS challenged Boise, but the Ninth Circuit Court of Appeals ruled in favor of the company. The vast majority of ESOP practitioners, as well as the ESOP Association and the NCEO, regarded the Boise decision as unjustifiable. Among other problems, it would mean employees would no longer be eligible to roll over their distributions or take net unrealized appreciation on them (since they now would be classified as dividends). The IRS had long indicated it would issue regulations to prevent such a practice in the future, and this proposal does just that.

The same proposal also states that deductions for qualifying dividends on ESOP shares must be taken at the parent company level, not the subsidiary. This means that a foreign corporation that sponsors a U.S. ESOP, such as DaimlerChrysler, BP, and others, will have to try to claim the deduction under the laws of their own country, something few if, any, can do. There appear to very few U.S. ESOPs in subsidiaries of foreign companies, however.