The Internal Revenue Service is fighting the 9th U.S. Circuit Court of Appeals over the deductibility of some dividends that employers pay to employee stock ownership plans.[@@]

The battle could affect employers that lay off workers, then use ESOP stock buybacks to cash workers out of the ESOPs.

The San Francisco-based 9th Circuit Court ruled in 2003 that employers can deduct dividends used to buy their own stock from affiliated ESOPs. The 9th Circuit ruling, issued in connection with Boise Cascade Corp. vs. United States, has the force of law in Alaska, Arizona, Hawaii, Idaho, Nevada, Oregon and Washington as well as in California.

But IRS officials argue in the preamble to new proposed regulations that the 9th Circuit interpretation could hurt employees, by exposing employees who belong to ESOPs to involuntary cash-outs and unexpected tax bills.

The proposed regulations would repeat the IRS position that sections 162(k) and 404(k) of the Internal Revenue Code forbid employers from deducting payments made in connection with stock buybacks from affiliated ESOPs, according to John Ricotta, an IRS tax exempt entities specialist, and Martin Huck, an IRS corporate taxation specialist.

The regulations are supposed to take effect 90 days after the IRS publishes the proposed draft in the Federal Register.

Even before the date the regulations take effect, “the IRS will continue to assert in any matter in controversy outside the 9th Circuit that sections 162(k) and 404(k) disallow a deduction for payments to reacquire employer securities held by an ESOP,” Ricotta and Huck write in the preamble to the proposed regulations.

The 9th Circuit held that employers could deduct dividend payments used to buy company stock back from ESOPs because the employer’s move to pay dividends to the ESOP and the ESOP’s move to pay the cash to the plan participants were 2 separate transactions.

But the IRS argues that, in addition to being bad for employees, allowing dividend deductions for ESOP stock buybacks is bad tax law. Allowing the deductions lets employers claim deductions both when they contributed stock to ESOPs and again when they paid to redeem the same stock, Ricotta and Huck write.

The IRS has posted a link to a copy of the proposed regulations on the Web site of its parent, the U.S. Treasury Department, at http://www.treasury.gov/press/releases/js2693.htm