rr-01-06.pdf

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Part I
Section 404.--Deduction For Contributions Of An Employer To An Employees=
Trust Or Annuity Plan And Compensation Under A Deferred-Payment Plan
Rev. Rul. 2001-6
ISSUE
Whether payments in redemption of stock held by an ESOP that are used to
make distributions to terminating ESOP participants constitute Aapplicable dividends@
under section 404(k)(1) of the Internal Revenue Code that are deductible.
FACTS
Corporation A (a C corporation) has a single class of voting common stock
outstanding. Corporation A maintains an employee stock ownership plan (ESOP), as
defined in section 4975(e)(7) of the Internal Revenue Code (Code), which holds stock
of Corporation A. The terms of the ESOP provide that when Corporation A pays
dividends on its stock, the ESOP trustee may 1) allocate the dividends on the employer
securities in a participant=s account to the participant; 2) allocate the dividends on the
employer securities in a participant=s account to the plan and distribute it in cash to the
participant not later than 90 days after the close of the plan year in which paid; or 3) use
the dividends on employer securities allocated to a participant=s account to repay a loan
to the ESOP the proceeds of which were used to acquire the employer securities,
provided that employer securities with a fair market value at least equal to the value of
those dividends are allocated to the participant=s account.
Under the plan, participants may elect to take a distribution in cash or stock at
retirement or termination of employment. In the current year, 100 participants with
account balances from $2,000 to $200,000, totaling $5 million, separate from service,
become eligible for distributions from the ESOP, and elect cash distributions. As
allowed under the plan, Corporation A redeems the shares in the terminating
participants= accounts for $5 million immediately prior to the distributions. Corporation
A claims that the redemptions are treated as dividends under the applicable rules of
sections 301, 302, and 316.
The ESOP pays the $5 million redemption proceeds to the terminating
participants within 90 days after the close of the plan year in which the plan received
the proceeds.
LAW AND ANALYSIS

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Section 162(k)(1) provides, with exceptions not relevant here, that no deduction
otherwise allowable under Chapter 1 is allowed for any amount paid or incurred by a
corporation in connection with the reacquisition of its stock or of the stock of any related
person (as defined in section 465(b)(3)(C)).
Section 404(k)(1) of the Code provides that, in the case of a C corporation, there
is allowed as a deduction for a taxable year the amount of any applicable dividend paid
in cash by such corporation during the taxable year with respect to applicable employer
securities. This deduction is in addition to the deductions allowed in section 404(a).
Section 404(k)(2)(A) provides, in relevant part, that the term Aapplicable
dividend@ means any dividend which, in accordance with plan provisions, is paid to the
plan and is distributed in cash to participants in the plan or their beneficiaries not later
than 90 days after the close of the plan year in which 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 a participant or beneficiary.
Section 404(k)(5)(A) provides that the Secretary may disallow the deduction
under paragraph (1) for any dividend if the Secretary determines that such dividend
constitutes, in substance, an evasion of taxation.
Under these facts, redemption payments are paid in connection with the
Areacquisition@ of the issuer=s stock. Thus, section 162(k)(1) bars the deduction of such
payments without regard to whether they would otherwise be deductible under section
404(k).
Moreover, the treatment of redemption proceeds as Aapplicable dividends@ under
section 404(k) would produce such anomalous results that section 404(k) cannot
reasonably be construed as encompassing such payments. See, e.g.
, Helvering v.
Hammel, 311 U.S. 504, 510-511 (1941) (the words of a statute must be given Aa
restricted rather than a literal or usual meaning . . . where acceptance of that meaning
would lead to absurd results . . . or would thwart the obvious purpose of the statute.@)
The application of section 404(k) to redemption amounts not only would allow
employers to claim deductions for payments that do not represent true economic costs,
but also would vitiate important rights and protections for recipients of ESOP
distributions, including the right to reduce taxes by utilizing the return of basis provisions
under section 72, the right to make rollovers of ESOP distributions received upon
separation from service, and the protection against involuntary cash-outs. See sections
72(e)(5)(D) and 411(a)(11)(C); section 1.402(c)-2, A-4(e) of the Income Tax
Regulations. Therefore, the term Aapplicable dividends@ under section 404(k) does not
include amounts paid for the redemption of stock held by an ESOP, whether or not
such redemption proceeds constitute dividends under sections 301, 302, and 316.

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Further, section 404(k)(5)(A) authorizes the Secretary to disallow a deduction
under section 404(k)(1) for any dividend that constitutes, in substance, an evasion of
taxation. Pursuant to section 404(k)(5)(A), a deduction under section 404(k)(1) would
be disallowed for payments in redemption of employer securities used to make
distributions to terminating ESOP participants because such treatment would constitute,
in substance, an evasion of taxation.
HOLDING
Payments in redemption of stock held by an ESOP that are used to make
distributions to terminating ESOP participants are not deductible. In addition, such
payments do not constitute Aapplicable dividends@ under section 404(k)(1) of the
Internal Revenue Code. This revenue ruling applies without regard to whether there is
appreciation in the employer securities in the ESOP.
DRAFTING INFORMATION
The principal authors of this revenue ruling are Steven J. Linder of the Employee
Plans, Tax Exempt and Government Entities Division (T:EP) and John T. Ricotta of the
Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government
Entities). For further information regarding this revenue ruling, please contact the
Employee Plans= taxpayer assistance telephone service between the hours of 1:30 and
3:30 p.m. Eastern time, Monday through Thursday, by calling (202) 283-9516. Mr.
Linder=s number is (202) 283-9888. Mr. Ricotta=s number is (202) 622-6060. (These
telephone numbers are not toll-free.)