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, 2017, Owl established an employee stock ownership plan (ESOP) that later received a favorable determination letter from the IRS.
On February 1, 2017, 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.