Peculiar Decision Allows General Mills Deduction for Redemptive Dividends Used for ESOP Distributions

In General Mills v. United States, No. 06-3547 (DSD/SRN, Jan. 14, 2008), a district court granted summary judgment to the company for its use of a redemptive dividend to pay ESOP distributions. General Mills had three ESOPs operating in a single trust. Employees could receive their distributions in cash or shares. During the 1990s, General Mills periodically redeemed shares of stock in the trust to handle part of the cash distributions. The company contended these payments of distributions were deductible dividends under Code Section 404(k), which allows companies to take a tax deduction for certain dividend payments on ESOP shares. The IRS denied the deduction and the company sued.

The IRS challenged the deduction under the doctrine set out by its chief counsel in Revenue Ruling 2001-6, which was issued in response to a decision in the Ninth Circuit allowing Boise Cascade to claim payments for repurchase of shares as 404(k) dividends. While the General Mills approach was slightly different in mechanics, the effect was the same. In Revenue Ruling 2001-6, the IRS said such redemptive dividends did not qualify as deductible items. Moreover, the IRS argued that Section 162(k) of the Code prohibits companies from taking deductions for stock redemptions.

The district court concluded that Section 162(k) did not apply because the General Mills redemptions were made through the ESOP for the purpose of cashing out employees. It also rejected the applicability of Revenue Ruling 2001-6 because, it said, the parties had stipulated that the ruling was from the chief counsel, but the judge concluded that only the Secretary of the Treasury could deny the deduction. The ruling itself, the court essentially concluded, had no force.

The use of dividends this way raises serious concerns among ESOP practitioners. First, it means companies get a deduction twice, once for contributing the dividend to repay the ESOP loan (as happened here) and again for redeeming the stock with another dividend. Worse, the employees now may not be able to take favorable tax treatment on these distributions by, for example, rolling them into other plans, if the IRS concludes the distributions are dividends. It is not clear whether the IRS will challenge the ruling or whether other companies have used this or now will.