T.C. Memo. 2011-2
UNITED STATES TAX COURT
MICHAEL C. HOLLEN, D.D.S., P.C., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 19618-08R. Filed January 4, 2011.
Michael C. Hollen (an officer), for petitioner.
Sarah S. Sandusky and Matthew M. Johnson, for respondent.
MEMORANDUM OPINION
LARO, Judge: Petitioner seeks a declaratory judgment under
section 7476 that its employee stock ownership plan (ESOP), the
Michael C. Hollen, D.D.S., P.C., Employee Stock Ownership Plan,
and its related employee stock ownership trust (ESOT) are
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qualified under sections 401(a) and 501(a), respectively.1
Respondent determined that the ESOP and the ESOT did not qualify
under sections 401(a) and 501(a), respectively, for the plan year
ended October 31, 1987 (1987 plan year), and for all plan years
thereafter. We sustain that determination.
Background
The parties filed a joint motion for leave to submit this
case for decision under Rule 122. We granted their motion and
decide this case on the basis of the pleadings and the stipulated
administrative record. See Rule 217(a). We incorporate the
stipulated record herein.
Petitioner is a professional corporation that reports its
income and expenses on the basis of the calendar year. It
employs its principal shareholder, Michael C. Hollen (Dr.
Hollen), as a dentist and as a corporate officer. Its principal
place of business was in Iowa when the petition was filed.
Petitioner began sponsoring the ESOP on November 1, 1986.2
The ESOP’s administrator is Dr. Hollen; he also is the ESOT’s
trustee. The ESOP’s plan year initially ended on October 31 but
1
Unless otherwise noted, section references are to the
applicable versions of the Internal Revenue Code, and Rule
references are to the Tax Court Rules of Practice and Procedure.
2
The earliest plan document in the record is from Sept. 15,
1994. The record is unclear whether the plan applied for or
received a favorable determination letter from the Internal
Revenue Service at inception.
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was changed in 2001 to end on December 31. As of its plan year
ended December 31, 2002, the ESOP had 15 participants and/or
beneficiaries.
The ESOT’s primary asset was stock in petitioner. On
October 12, 17, and 18, 1989, the ESOT borrowed a total of
$416,920 and used those proceeds to purchase a total of 130,696
shares of petitioner’s stock. During the ESOP’s plan year ended
October 31, 1989 (1989 plan year), petitioner distributed
$200,000 to the ESOT, and the ESOT used the $200,000 to repay a
like amount of the borrowings. In connection with that
repayment, the ESOT allocated $200,000 of petitioner’s common
stock to the accounts of the ESOP participants; $150,339 of that
allocation went to Dr. Hollen’s account.
Petitioner retained Stephen Thielking (Thielking) as the
ESOP’s accountant. Thielking is a certified public accountant,
and he appraised the stock held by the ESOT in 2001, 2002, and
2003.
On January 1, 2001, the ESOP was amended effective as of
that date. On December 27, 2002, petitioner requested a
determination from the Commissioner as to the qualified status of
the ESOP as amended in 2001. Petitioner withdrew that request on
August 4, 2003. On May 15, 2008, the Commissioner issued a final
nonqualification letter, which underlies this proceeding.
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Discussion
Section 7476(a) authorizes this Court to render the
requested declaratory judgment, subject to the limitations of
section 7476(b). Neither party argues that any of those
limitations is not met, and we are satisfied that we have
jurisdiction over the petition. See generally Efco Tool Co. v.
Commissioner, 81 T.C. 976 (1983) (discussing this Court’s
jurisdiction in the setting of a declaratory judgment case such
as this).
Respondent determined that the ESOP and the ESOT failed to
qualify under sections 401(a) and 501(a), respectively, because:
(1) The ESOP was not timely amended to include provisions
required by sections 402(c)(4)(C), 414(n)(2)(C), (q), and (u),
and 415(c)(3); (2) the ESOP failed to follow the vesting schedule
required by section 411(a)(2)(B); (3) the ESOP failed to use an
independent appraiser to appraise employer securities as required
by section 401(a)(28)(C); and (4) the beneficiary account of Dr.
Hollen exceeded the allowable amount of annual additions for the
1989 plan year.
Respondent’s determination is presumed to be correct, and
the burden of proof is on petitioner.3 See Rule 142(a); Welch v.
3
In certain cases, sec. 7491(a) places the burden of proof
on the Commissioner “with respect to any factual issue relevant
to ascertaining the liability of the taxpayer for any [Federal
income or estate] tax”. We need not decide whether sec. 7491(a)
(continued...)
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Helvering, 290 U.S. 111, 115 (1933). To prevail, petitioner must
prove that respondent abused his discretion. Under this
standard, petitioner must persuade the Court that respondent’s
determination was unreasonable, arbitrary, or capricious. See
Buzzetta Constr. Corp. v. Commissioner, 92 T.C. 641, 648 (1989).
Petitioner has failed to do so.
Section 401(a) lists requirements which must be met in order
for a trust to be considered a qualified trust entitled to
preferential tax treatment under section 501(a). See generally
Ronald R. Pawlak, P.C. v. Commissioner, T.C. Memo. 1995-7
(discussing the types of preferential tax treatment under section
501(a)). In addition, the Employee Retirement Income Security
Act of 1974, Pub. L. 93-406, sec. 402(a)(1), 88 Stat. 875,
requires that the plan be in writing. See also sec.
1.401-1(a)(2), Income Tax Regs. Congress established the writing
requirement so that every employee may, on examining the plan
document, determine exactly what his or her rights and
obligations are under the plan and who is responsible for
operating the plan. See Curtiss-Wright Corp. v. Schoonejongen,
514 U.S. 73, 83 (1995); H. Conf. Rept. 93-1280, at 297 (1974),
3
(...continued)
applies to declaratory judgment actions such as this. This is
because sec. 7491(a) is not applicable where, as here, the
taxpayer makes no argument as to the applicability of the section
and fails to show that the prerequisites for its applicability
have been met.
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1974-3 C.B. 415, 458. With these basic principles in mind, we
turn to analyzing respondent’s determination as to the ESOP’s
qualification under section 401(a). We do not specifically
discuss the qualification of the ESOT under section 501(a)
because the exemption of the ESOT under section 501(a) follows
from the qualification of the ESOP under section 401(a). See
Ronald R. Pawlak, P.C. v. Commissioner, supra.
Disqualifying Reason 1: ESOP Not Properly Amended
The Small Business Job Protection Act of 1996, Pub. L.
104-188, 110 Stat. 1755, and the Internal Revenue Service
Restructuring and Reform Act of 1998, Pub. L. 105-206, 112 Stat.
685, amended the plan qualification requirements under sections
402(c)(4)(C) (eligible rollover distributions), 414(n)(2)(C)
(definition of employee leasing), 414(q) (definition of highly
compensated employee), 414(u) (special rules for veterans), and
415(c)(3)(D) (participants’ compensation). Respondent determined
that the ESOP did not qualify under section 401(a) because it was
not timely amended to reflect these laws.
Petitioner did not amend the ESOP in accordance with the
effective dates set forth in the referenced statutes. All the
same, the ESOP may retroactively qualify under section 401(a) if
remedial amendments were made during the remedial amendment
period described in section 1.401(b)-1, Income Tax Regs. That
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section provides that a plan such as the ESOP may qualify
retroactively if:
on or before the last day of the remedial amendment
period * * * with respect to such disqualifying
provision, all provisions of the plan which are
necessary to satisfy all requirements of sections
401(a), 403(a), or 405(a) are in effect and have been
made effective for all purposes for the whole of such
period. * * * [Sec. 1.401(b)-1(a), Income Tax Regs.]
For this purpose, the last day of the remedial amendment period
is determined by reference to section 1.401(b)-1, Income Tax
Regs. In accordance with that section and with Rev. Proc.
2001-55, 2001-2 C.B. 552, the last day of the remedial amendment
period at issue was February 28, 2002.4
The chart below shows the effective dates for sections
402(c)(4)(C), 414(n)(2)(C), (q), and (u), and 415(c)(3)(D), the
dates on which the ESOP adopted its related amendments, and the
dates on which the ESOP made each of those amendments effective.
Required Amendment Amendment
Effective Adopted Effective
Section Date Date Date
402(c)(4)(C) Jan. 1, 1999 Jan. 1, 2001 Jan. 1, 2001
414(n)(2)(C) Nov. 1, 1997 Jan. 1, 2001 Jan. 1, 2001
414(q) Nov. 1, 1997 Jan. 1, 2001 Jan. 1, 2001
414(u) Dec. 12, 1994 Jan. 1, 2001 Jan. 1, 2001
415(c)(3)(D) Dec. 31, 1997 Jan. 1, 2001 Jan. 1, 2001
4
The remedial amendment period extension provision of sec.
1.401(b)-1(e)(3), Income Tax Regs., does not apply because
petitioner requested the determination letter on Dec. 27, 2002,
after the remedial amendment period expired.
-8-
Although the ESOP adopted its amendments on January 1, 2001,
before the expiration of the remedial amendment period, the
amendment failed to make the provisions effective as of the
required effective dates. The ESOP is therefore not qualified
under section 401(a) because the required provisions failed to be
effective for the whole of the remedial amendment period. See
sec. 1.401(b)-1, Income Tax Regs.; see also Ronald R. Pawlak,
P.C. v. Commissioner, supra.
Disqualifying Reason 2: Certain Plan Participants Not Credited
According to Vesting Schedule
Section 401(a)(7) requires that the ESOP satisfy the vesting
requirements of section 411. Section 411(a)(2)(B)(iii) provides
for a vesting schedule whereby an employee vests in plan benefits
over a period of 6 years, pro rata. The ESOP’s plan document
reflects the vesting schedule required by law, but the ESOP in
operation did not follow that schedule. The following chart
shows the vesting percentages reflected in the ESOP’s records
compared with those required under section 411(a)(2).5
Vesting Percentage Vesting Percentage
Employee Per Plan Records Required Under Sec. 411(a)(2)
Ann Tarr -0- 80
Susan Bess 40 100
Jodi Robinson 20 -0-
Cynthia Dunn -0- 40
Kerry Newland -0- 20
Sarah Wheeter -0- 40
5
Petitioner claims that “any required corrections have been
made”, but the record does not substantiate this claim.
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The ESOP fails to qualify under section 401(a) because it
did not properly vest in operation in accordance with the
schedule required by the plan. See sec. 1.401-1(b)(3), Income
Tax Regs. (stating that “The law is concerned not only with the
form of a plan but also with its effects in operation”); see also
Winger’s Dept. Store, Inc. v. Commissioner, 82 T.C. 869, 876
(1984) (stating that “the operation of the trust is as relevant
as its terms”); Quality Brands, Inc. v. Commissioner, 67 T.C.
167, 174 (1976) (holding to the same effect). Petitioner offers
no explanation as to why the vesting schedules on the ESOP’s
books did not properly reflect the provisions of the plan
document’s vesting schedule. Moreover, petitioner declined
respondent’s offer to participate in a closing agreement program
(CAP) which would allow for retroactive compliance. Because the
ESOP was not operationally in compliance, we hold that it failed
the requirements of section 411 (and hence section 401).
Disqualifying Reason 3: ESOP Failed To Use Independent Appraiser
Petitioner asserts that Thielking was a permissible
appraiser of the ESOT’s stock in petitioner. We hold otherwise.
Section 401(a)(28)(C) provides that all employer securities which
are not readily tradable on an established securities market must
be valued by an “independent appraiser”. Since petitioner’s
stock is not traded on an established securities market, an
independent appraiser had to value the ESOT’s holdings of that
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stock. As relevant here, an “independent appraiser” means a
“qualified appraiser” as defined by section 1.170A-13(c)(5)(I),
Income Tax Regs.
The ESOP fails at least two requirements of that section.
First, section 1.170A-13(c)(5)(i), Income Tax Regs., requires
that the appraisal summary contain a declaration that the
individual holds himself out to the public as an appraiser. The
appraisal letters covering the 2001 through 2003 plan years state
that “The undersigned holds himself out to be an appraiser”.
However, there is no signature below that statement on any of the
letters (there is an unsigned line for a signature with the word
“appraiser” typed below). Second, section 1.170A-13(c)(3)(ii)(F)
and (5)(i)(B), Income Tax Regs., requires that the qualified
appraiser who signs the appraisal must list his or her
background, experience, education, and membership, if any, in
professional appraisal associations. The appraisal here is not
signed, and the appraisal summary does not list the referenced
information.
We conclude that the ESOT’s holdings of petitioner’s stock
were not valued by a “qualified appraiser” and that the ESOP
therefore fails the requirements of section 401(a)(28)(C) (and
hence section 401(a)). Petitioner does not assert that the
substantial compliance doctrine applies. See Bond v.
Commissioner, 100 T.C. 32 (1993).
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Disqualifying Reason 4: Excess Annual Additions Allocated to Dr.
Hollen
Section 401(a)(16) provides that a trust is not qualified if
the plan “provides for benefits or contributions which exceed the
limitations of section 415.” For the 1989 plan year, a
participant’s annual additions were limited to the lesser of
$30,000 or 25 percent of the participant’s compensation. See
sec. 415(c)(1).
The parties dispute whether respondent properly
recharacterized $150,339 of the $200,000 dividend paid to the
ESOP as an annual addition subject to the limitations of section
415(c). The term “annual addition” includes employer
contributions, employee contributions, and forfeitures. See sec.
415(c)(2). The term generally does not include a dividend on
employer stock distributed to an employee stock ownership plan
which uses the distributed proceeds to pay interest and principal
on an employer securities acquisition loan. See id.; see also
sec. 404(a)(9). Section 1.415-6(b), Income Tax Regs., however,
recognizes that certain transfers to such a plan, although not
labeled as a contribution or forfeiture, may in fact be an annual
addition. To combat such abuse, section 1.415-6(b)(2)(i), Income
Tax Regs., allows the Commissioner “in an appropriate case,
considering all of the facts and circumstances, [to] treat
transactions between the plan and the employee or certain
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allocations to participants’ accounts as giving rise to annual
additions.” Respondent treated $150,339 of the $200,000 dividend
as such an annual addition to Dr. Hollen’s account.
We review that determination for abuse of discretion, and we
find none. Dr. Hollen was the primary beneficiary of the
$200,000 dividend distributed to the ESOT and of the ESOT’s use
of those proceeds to repay a like amount of the borrowings
obtained to purchase the stock of petitioner. That repayment was
of funds borrowed by the ESOT to buy $200,000 of common stock
held by the ESOT, approximately 75 percent of which was allocated
to the account of Dr. Hollen. The effect of the financing, which
was proximate to the distribution, was to provide petitioner with
a deduction for the principal payments on the loans, see sec.
404(a)(9)(A), without any corresponding income recognition by
either petitioner or the ESOT. This in turn increased the value
of the stock held by the ESOT (primarily to Dr. Hollen’s benefit)
by the value of the income tax savings. Given these facts, we do
not believe that respondent abused his discretion when he
recharacterized the $150,339 in “earnings” allocated to Dr.
Hollen as an annual addition. See Steel Balls, Inc. v.
Commissioner, T.C. Memo. 1995-266, affd. without published
opinion 89 F.3d 841 (8th Cir. 1996).
We conclude that the ESOP failed the requirement of section
401(a)(16) for the 1989 plan year because Dr. Hollen’s ESOT
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account received an annual addition in excess of the limitations
of section 415(c). Because the ESOP never took any action to
correct this failure, the ESOP also was not qualified in plan
years after that date. See Clendenen v. Commissioner, T.C. Memo.
2003-32, affd. 345 F.3d 568 (8th Cir. 2003); see also Martin
Fireproofing Profit-Sharing Plan & Trust v. Commissioner, 92 T.C.
1173, 1184 (1989) (stating that “corrective action of the sort
set forth in the regulations is a prerequisite to requalification
of a trust, following a violation of section 415”). Petitioner
had the opportunity to correct this failure through the CAP but
chose not to do so. We hold that the ESOP is disqualified for
1989 and for all subsequent plan years.
Conclusion
We sustain respondent’s determination that the ESOP and ESOT
were disqualified for the 1987 plan year and for all plan years
thereafter.6 We have considered all arguments made by petitioner
for holdings contrary to those expressed herein and reject these
arguments not discussed herein as irrelevant or without merit.
Accordingly,
Decision will be entered
for respondent.
6
We uphold respondent’s determination that the ESOP was
disqualified for the 1987 and 1988 plan years because there is no
plan document in the record for those years.