Must Reflect Qualified ESOP Dividend in Adjusted Current Earnings For Purposes of Computing AMT

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Shortly after the plan was established, * * *'s * * * shareholders transferred * * * shares of * * * to the ESOP. This transfer represented * * * percent of the outstanding common stock of * * *. As part and parcel of this transfer, the ESOP entered into a loan agreement with the * * * bank for $* * *. The ESOP used the entire amount of the loan proceeds to pay the stock transferors consideration for the stock.

During its taxable year * * *, * * *, through its Board of Directors, declared dividends. * * * paid a cash dividend to the ESOP in the amount of $* * *. The ESOP transferred the entire amount of the dividend to the * * * bank in payment of interest and principal. On or about * * *, the loan from * * * bank was refinanced with a loan from * * *.

Standard of Review

Regulations can be either legislative or interpretive in character. Estate of Pullin v. Commissioner, 84 T.C. 789, 795 (1985). An interpretive regulation is issued under the general authority vested in the Secretary by I.R.C. § 7805, whereas a legislative regulation is issued pursuant to a specific congressional delegation to the Secretary. In section 7611(g) of the Omnibus Budget Reconciliation Act of 1989, 103 Stat. 2106 (1989), Congress directed the Secretary of the Treasury to prescribe regulations, by March 15, 1991, providing guidance as to which items of deduction are disallowed under section 56(g)(4)(C) of the Code. Accordingly, Treas. Reg. § 1.56(g)-1(d)(3)(iii)(E) is a legislative regulation.

The Supreme Court has articulated a general standard for evaluating the validity of regulations, as follows:

ESOP Dividends

Section 404(k) provides that an employer-corporation shall be allowed a deduction for regular tax purposes for any ESOP dividend that is: (1) paid in cash to ESOP participants or their beneficiaries, (2) paid to the ESOP and distributed in cash to ESOP participants or their beneficiaries within 90 days of the plan year in which paid, or (3) used to make payments on a loan the proceeds of which were used to acquire securities of the employer. Pursuant to I.R.C. § 404(k), * * * properly deducted the ESOP dividend payment.

Alternative Minimum Tax/Adjusted Current Earnings

In order to restore fairness to the Internal Revenue Code, Congress adopted the corporate alternative minimum tax (AMT) as part of the Tax Reform Act of 1986. As expressed by the Senate Finance Committee, Congress believed that "the minimum tax should serve one overriding objective: to ensure that no taxpayer with substantial economic income can avoid significant tax liability by using exclusions, deductions, and credits." S. Rep. No. 313, 99th Cong., 2d Sess. 518 (1986).

For taxable years beginning after December 31, 1986, section 55 provides that a corporation's AMT is equal to the excess of the corporation's tentative minimum tax over its regular tax. Under section 55(b)(1), the tentative minimum tax of a corporation is defined as 20 percent of the excess of alternative minimum taxable income over an exemption amount determined under section 55(d), reduced by the AMT foreign tax credit for the taxable year. Alternative minimum taxable income is the taxable income of the corporation determined with the adjustments provided in section 56 and section 58, and increased by the preferences described in section 57.

One of the alternative minimum tax adjustments applicable to corporations for tax years after 1989 is the adjustment in section 56(g) for adjusted current earnings (ACE). The ACE adjustment is equal to 75 percent of the excess, if any, of the ACE of the corporation for the taxable year over the pre-adjustment alternative minimum taxable income of the corporation for the taxable year. Pre-adjustment alternative minimum taxable income is the alternative minimum taxable income of the corporation for the taxable year, determined without the adjustment for ACE and without the alternative tax net operating loss deduction. Though * * * properly deducted the ESOP dividend payment, it failed to include the ESOP dividend in its computation of the corporate alternative minimum tax as is required under I.R.C. § 56(g) and Treas. Reg. § 1.56(g)-1(d)(3)(iii)(E).

ACE is designed to be at least as broad a tax base, on a cumulative basis, as pre-adjustment alternative minimum taxable income and is also designed to be a measure of income that is at least as broad as pre-tax net book income as measured for financial reporting purposes. H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-275 (1986); Staff of the Joint Committee on Taxation, 99th Cong., 1st Sess., General Explanation of the Tax Reform Act of 1986 435, 457 (Joint Comm. Print 1987). Accordingly, in arguing against * * *'s assertion that ESOP dividends are deductible for ACE purposes the fact that Congress intended ACE to be a broad-based measurement of economic income should be stressed.

In general, ACE includes all income items that are taken into account in determining current earnings and profits (E&P) if the items are not already includible in pre-adjustment alternative minimum taxable income. An item is generally not deductible for ACE purposes, however, unless it is deductible in determining both pre-adjustment alternative minimum taxable income and current E&P.

Section 56(g)(4)(C)(i) of the Internal Revenue Code, which is part of the corporate ACE adjustment, provides: "In General. -- A deduction shall not be allowed for any item if such item would not be deductible for any taxable year for purposes of computing earning and profits." Although the Code nowhere defines the term "earnings and profits," section 56(g)(5)(A) does state that "[t]he term 'earnings and profits' means earnings and profits computed for purposes of subchapter C."

In Treasury Regulation section 1.56(g)-1(d)(3), the Service set forth as part of the ACE regulations a partial list of items that are not deductible in computing earnings and profits. Included in the list are dividends paid to an ESOP, which are deductible for regular tax and pre-adjustment alternative minimum tax purposes under section 404(k). Treas. Reg. § 1.56(g)-1(d)(3)(iii)(E).

As explained in the Preamble to the Proposed ACE regulations, the Service determined that ESOP dividends are not deductible for ACE purposes based on unambiguous language in the Conference Committee Report for the Tax Reform Act of 1986. Preamble to the ACE Regulations, 55 Fed. Reg. 18,626, 18,628 (May 14, 1990). The 1986 Act Conference Committee Report states:

Although the first and last sentences in the above-quoted paragraph would appear to clearly cover the issue of the deductibility of dividends for ACE purposes, * * * can be expected to try to distinguish between what will be termed "normal" dividends and ESOP dividends. There is, however, no basis in the statute or the legislative history for making such a distinction.

There are distributions which are called "dividends" that are not made with respect to stock. Such "dividends" are not treated as dividends under section 301(a) and do reduce current E&P for purposes of determining the amount available for distribution as a dividend. Accordingly, these "dividends" are deductible for purposes of computing both pre-adjustment alternative minimum taxable income and ACE. The Preamble to the ACE regulations states that no ACE adjustment is required for "dividends" paid on deposits by thrift institutions deductible under section 591, life insurance policyholder dividends deductible under section 808, and patronage dividends of cooperatives deductible under section 1382(b) because these items are not true dividends since they are not paid with respect to stock.

On the other hand, dividend distributions made with respect to stock that are deductible for pre-adjustment alternative minimum tax purposes are nevertheless not deductible for ACE purposes. Examples of these kinds of dividends include dividends paid by public utilities with respect to certain preferred stock under section 247, nonpatronage dividends paid by certain cooperatives under section 1382(c)(1), and ESOP dividends. These items are true dividends, paid with respect to stock, and thus are not deductible in computing ACE.

* * * may also argue that ESOP dividends are deductible for ACE purposes because ACE is based on earnings and profits and dividends are deductible in determining earnings and profits. Whether an item is a dividend and what is the effect of a dividend on E&P, however, are separate questions. Whether an item is a dividend necessarily must be answered before the effect of the dividend on the corporation's E&P is considered. Otherwise, a corporation could declare a dividend that would reduce its E&P and convert a dividend distribution into a non-dividend distribution (assuming insufficient accumulated E&P). Because the character of a distribution as a dividend depends upon the amount of E&P that is available for distribution, the amount of available E&P must be determined before any reduction of E&P for dividend distributions.

Section 316 ("Dividend Defined") provides that a distribution by a corporation to its shareholders is a dividend to the extent the corporation has earnings and profits. Determining the extent of a corporation's earnings and profits is necessary in order to differentiate between a corporate distribution that is out of the profits generated by the operations of the corporation (a taxable dividend to the shareholders) and a distribution by the corporation that is merely a return of the shareholders' original investment in the corporation (a return of capital, nontaxable to the shareholders) or a distribution that is a capital gain (taxable as capital gain income).

In determining whether there are sufficient earnings and profits in a corporation to characterize a particular corporate distribution as a dividend, section 316(a) provides that the amount of the current year's earnings and profits is considered first. If the corporation has current year earnings and profits that equal or exceed the amount of the distribution, the whole amount will be a dividend to the shareholders. If there are insufficient current year earnings and profits to characterize the entire amount of the distribution as a dividend, then accumulated earnings and profits are considered. A distribution in excess of the current year's earnings and profits will be a dividend to the shareholders if accumulated earnings and profits equal or exceed the amount of the excess. Section 316(a)(2) specifically states that in determining the amount of earnings and profits for the current year that are available to characterize a corporate distribution as a dividend, any distributions made during the current year are not deducted.

* * * may argue that dividends are deductible for earnings and profits purposes based on section 312, which provides that a distribution by a corporation to its shareholders decreases the corporation's earnings and profits. Section 312, however, sets forth the treatment of corporate distributions for purposes of determining the amount of current earning and profits that will be added to accumulated earnings and profits. Amounts that a corporation distributes to its shareholders obviously will not be available to be added to accumulated earnings and profits at the end of the year. Likewise, the amount of a corporation's earnings and profits for a particular year is not diminished by the amount that it distributes to its shareholders as dividends.

Thus, section 312 does not provide that dividend distributions are deducted in computing the amount of earnings and profits for the current year. When read in conjunction with section 316, section 312 merely provides that reductions in the amount of current earnings and profits to be added to accumulated earnings and profits are necessary in order to determine the amount of earnings and profits available in later years to characterize corporate distributions as dividends. H. James Williams, Earnings and Profits, 762 Tax Management Portfolio A-38 (1992).

ESOP Dividends as Compensation

Finally, * * * may also try to argue that ESOP dividends are not "dividends" for ACE purposes because they are a form of employee compensation and should be deductible as such for ACE purposes because compensation reduces E&P. We disagree with this argument for several reasons. In order for a distribution to be deductible as a dividend under I.R.C. § 404(k), it must qualify as a dividend. Under I.R.C. § 316(a), a dividend generally is a distribution of property made by a corporation to its shareholders, provided the distribution is out of the corporation's earning and profits.

The repayment of the ESOP loan with a nondeductible dividend is a prohibited transaction under I.R.C. § 4975. I.R.C. § 404(k) provides that no prohibited transaction results if deductible dividends are used to repay ESOP debt. Thus, an inference may be drawn that a prohibited transaction occurs if nondeductible dividends are used to repay ESOP debt.

For the taxable year at issue, I.R.C. § 404(k) of the Code, as amended by the Tax Reform Act of 1986, Pub. L.No. 99514 (TRA 86), and the Technical and Miscellaneous Revenue Act of 1988, Pub. L. No. 100-647 (TAMRA), provided that a deduction is allowed for dividends paid on stock held by an employee stock ownership plan (ESOP). Specifically, a deduction is allowed to a corporation for the amount of any dividend paid in cash with respect to the stock of such corporation held on the record date for the dividend by an ESOP (as defined in I.R.C. § 4975(e)(7)), provided the dividend is either (A) paid in cash to participants, (B) paid to the plan and shortly thereafter distributed in cash to participants, or (C) used to make payments on a loan described in I.R.C. § 404(a)(9). A deduction under I.R.C. § 404(k)(2)(C) as in effect for the taxable year at issue is allowable in the taxable year of the corporation in which the dividend in used to repay the loan described in I.R.C. § 404(a)(9).

The Senate Report to TRA 86, S. Rep. No. 99-313, 1986-3 C.B. Vol. 3, 1034, states as follows:

Congress intended leveraged ESOPs to serve as a corporate financing device as well as an employee benefit plan. In enacting TRA 86, Congress increased the tax benefits of maintaining a leveraged ESOP by allowing deductible dividends (as well as deductible contributions) to be used for the repayment of ESOP debt. Such a deduction was intended to further the goal of increased employee ownership of stock through the ESOP. The statute however, places limits on this deduction by authorizing the Secretary to disallow the deduction if such dividend constitutes, in substance, tax evasion. In this regard the legislative history indicates that deductible dividends must be "reasonable."

A comprehensive definition of a "reasonable" dividend (or one constituting an "evasion of taxation") is not found in the legislative history or in the income tax regulations. Nevertheless, in light of the legislative history it may be implied that a "reasonable" dividend within the meaning of I.R.C. § 404(k) contemplates a dividend of a rate that is normally paid in the ordinary course of business.

Stock in an ESOP can be either allocated directly to a participant's account or unallocated and deposited into a suspense account. See Treas. Reg. § 54.4975-11(c). It is not unusual for a leveraged ESOP to have most of its stock in an unallocated suspense account.¹ If the stock held by the ESOP is unallocated, the dividends paid on each share of stock held by the suspense account are distributed to the suspense account and are applied to the securities loan and its accompanying debt service. See I.R.C. § 404(k)(2)(A)(iii) and Treas. Reg. § 54.4975-7.

When the stock dividends are used to reduce the debt attached to the ESOP-held securities, the corporation receives a deduction for the dividends paid to the suspense account. Additionally, as the securities debt is paid down, the stock held by the suspense account is allocated to the individual participant accounts. See Treas. Reg. 54.4975-7.

Lastly,