Owl, Inc., was owned entirely by Jeri Bell and Jerry Gore, each owning 620,000 of the 1,240,000 shares of common stock outstanding. On January 1, 2015, Owl established an employee stock ownership plan (ESOP) that later received a favorable determination letter from the IRS.
On February 1, 2015, Bell and Gore each sold 500,000 of their shares to the ESOP, each receiving $2.5 million. To facilitate the transaction, the ESOP borrowed $5 million from a local bank; the loan was guaranteed by Owl. During the year, Owl paid $1.4 million in cash dividends to the ESOP with respect to its stock. The ESOP transferred the cash to the bank as payment of principal and interest under the note.
Jeri Bell calls you and asks if Owl may claim a deduction under § 404(k) for the $1.4 million cash dividends. Does Owl have to include the dividends in its computation of ACE, thus avoiding any AMT? Write a memo for the tax files in response to Ms. Bell.
SOLUTION
TAX FILE MEMORANDUM
Date: March 16, 2015
From: Rob Hummock
Re: Owl, Inc., AMT/ESOP Request
The IRS will argue that the § 404(k) dividend is includible in the ACE calculation. This position was taken by the IRS in a Tax Court decision [Snap-Drape, Inc., 105 TC 16 (1995)].
The taxpayer argued that Treasury Reg. § 1.56(g)(1)(d)(3)(iii)(E), is an improper interpretation of § 56(g)(4)(C)(i), and, alternatively, that if the regulation is held valid, that the IRS abused its discretion in providing for retroactive application of the Regulation.
The Tax Court upheld the IRS, noting that the regulations in question are legislative, and thus entitled to an elevated degree of deference.
The Tax Court agreed with the IRS that “section 404(k) dividends are essentially equivalent to regular dividends,” and pointed out that generally, a corporation may not claim deductions for cash dividends. The court rejected Owl’s assertion that § 404(k) dividends are a form of compensation in that the statute exists under the deferred compensation provisions, and the benefit is ultimately received by employees.
The court stated that, in allowing corporations a deduction when their ESOPs use cash dividends to service debt incurred to acquire employer securities, Congress aimed at providing an incentive for corporations to establish ESOPs. However, the court asserted that Congress created the AMT regime “to ensure that each corporate taxpayer was in fact paying a fair share of tax.”
The IRS’s position, the court held, furthers both congressional aims, whereas Owl’s position would further only the first. The court also rejected Owl’s contention that “the regulation nullifies the benefit provided by section 404(k),” reasoning that Owl “may be entitled to claim a credit against regular tax in a subsequent year for the amount of AMT paid in the current year.”
With respect to retroactive application of Regulations, the Tax Court rejected Owl’s assertions that it justifiably relied on settled law that was altered by the Regulations and that the Regulations impose a harsh result.