The Employee Ownership Update
January 29, 2008
Peculiar Decision Allows General Mills Deduction for Redemptive Dividends Used for ESOP DistributionsIn 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.
Old Account of Employee Ownership at Proctor & Gamble Worth a LookProcter & Gamble set up an employee ownership plan in 1903 that allowed employees to buy stock for a 2.5% down payment, with the rest borrowed from the company, but repaid out of profit sharing (a 12% or more "dividend" on wages available only to those buying stock). The plan was not available to more highly paid employees. P&G would buy the stock back at the purchase price if the employee left and the stock had dropped in value. An absolutely fascinating account of the plan and the social attitudes of the time can be found in the 1914 book The World's Work in the chapter on profit sharing (click here to read it at Google Book Search).
The chapter's author, Janet Ruth Rankin, discusses how employees at the company commonly accumulated several years' or more in pay in stock value through the plan. "If you should see a workman whose weekly wage was $15, and were told the he owned $10,000 worth of stock earning 7%, yearly, your explanation of the fact would probably be that he had a rich and dead relative." But Rankin says it happened often at the company. She describes "Henry B________," who "came into the employ of the company as a more than incipient drunkard." But inspired by a coworker prospering in the plan, he started buying shares. "With the very first payment came a sense of security from financial worries-those things that drive many a poor workman to drink-and a real reason for saving kept Henry away from old haunts." Rankin writes that "profit sharing represents the democratic idea in relation of employer to employee and of employee to the business. And the democratic idea is the only idea that will work out in this democratic country."
The chapter is also fascinating as social history. Rankin, for instance, writes that some of the P&G employees are "Negroes who are employed in the company's Southern plants and are too ignorant to enter upon the profit sharing plan." Later, writing about women at the plant (some of whom, she says, have accumulated large sums in stock), she says they are, in general, "no more emancipated than their sisters of Boston. They do not think first of earning a stake for the future, if they think at all. More often, their families, who take their wages, think for them."