148 T.C. No. 22
UNITED STATES TAX COURT
STEVEN M. PETERSEN AND PAULINE PETERSEN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
JOHN E. JOHNSTUN AND LARUE A. JOHNSTUN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 15184-14, 15185-14. Filed June 13, 2017.
I.R.C. sec. 267(a)(2) defers deductions for expenses paid by a
taxpayer to a related person until the payments are includible in the
related person’s gross income. I.R.C. sec. 267(b) defines the “rela-
tionships” that bring this statute into play. I.R.C. sec. 267(e) provides
that, for purposes of applying subsec. (a)(2), an S corporation and
“any person who owns (directly or indirectly) any of the stock of such
corporation” shall be “treated as persons specified in a paragraph of
subsection (b).” I.R.C. sec. 267(e) thus deems S corporations and
their shareholders to be “related persons” regardless of how much or
how little stock each shareholder individually owns. I.R.C. sec.
267(c), which provides rules for constructive ownership of stock,
provides that stock owned by a “trust” is deemed constructively
owned by the beneficiaries of the trust.
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Ps were shareholders of a closely held S corporation. S formed
an ESOP for the benefit of its employees and transferred S stock and
cash to the related ESOP trust. During 2009 and 2010 S accrued pay-
roll expenses for employees who participated in the ESOP, but a por-
tion of these expenses remained unpaid at the end of each year. S
claimed deductions, and Ps as shareholders of S claimed flowthrough
deductions, for these accrued but unpaid payroll expenses. R disal-
lowed these deductions on the ground that the ESOP participants
were beneficiaries of a “trust”; that these employees were deemed by
I.R.C. sec. 267(c) to be constructive owners of the S stock held by the
trust; and hence that the ESOP participants and S were related per-
sons for purposes of I.R.C. sec. 267(b) and (a)(2).
1. Held: The entity holding the S stock for the benefit of the
ESOP participants is a “trust” within the meaning of I.R.C. sec.
267(c). I.R.C. sec. 267(c)(1) thus deems the stock held by the trust to
be owned by the trust’s beneficiaries, viz., the S employees who
participated in the ESOP.
2. Held, further, S and the ESOP-participating employees are
deemed by I.R.C. sec. 267(e) to be related persons for purposes of
I.R.C. sec. 267(b). I.R.C. sec. 267(a)(2) accordingly operates to defer
S’ deductions for the accrued but unpaid payroll expenses to the year
in which such pay was received by the ESOP employees and
includible in their gross income.
Michael C. Walch, for petitioners.
Rebekah A. Myers, for respondent.
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OPINION
LAUBER, Judge: With respect to petitioners Steven Petersen and Pauline
Petersen, the Internal Revenue Service (IRS or respondent) determined, for their
2009 and 2010 taxable years, the following Federal income tax deficiency, over-
payment,1 and accuracy-related penalty:2
Deficiency/ Penalty
Year Overpayment sec. 6662(a)
2009 $429,444 $85,889
2010 (44,466) -0-
With respect to petitioners John Johnstun and Larue Johnstun, the IRS de-
termined, for their 2009 and 2010 taxable years, the following Federal income tax
deficiency, overpayment, and accuracy-related penalty:
1
For each couple, the overpayment that the IRS determined for 2010 results
from applying, to the different facts of 2010, the legal theory that the IRS adopted
in determining the deficiency for 2009. As explained more fully below, we be-
lieve that legal theory to be correct, and we will accordingly sustain the deficien-
cies that the IRS determined for 2009. We do not appear to have jurisdiction to
determine an overpayment for 2010 because the IRS did not determine a deficien-
cy for that year. See secs. 6214(b), 6512(b)(1); Kupersmit v. Commissioner, T.C.
Memo. 2014-129. However, absent any statute of limitation concerns, we assume
that the IRS will credit each couple with the overpayment that the notice of de-
ficiency determined for 2010.
2
All statutory references are to the Internal Revenue Code (Code) in effect
for the relevant years, and all Rule references are to the Tax Court Rules of Prac-
tice and Procedure. We round all monetary amounts to the nearest dollar.
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Deficiency/ Penalty
Year Overpayment sec. 6662(a)
2009 $1,793 $359
2010 (144) -0-
These cases present a question of statutory interpretation involving section
267, which disallows or defers deductions for certain losses and expenses incurred
in transactions between related persons. Section 267(a)(2) provides that if a tax-
payer makes a deductible payment to a related person (as specified in subsection
(b)), that payment is not allowable as a deduction to the payor until it is includible
in the gross income of the payee. The question presented is whether this section
applies to defer certain deductions accrued by Petersen, Inc. (Petersen or the
company), an S corporation of which petitioners were the founders and original
shareholders.
Petersen uses the accrual method of accounting for Federal income tax pur-
poses. In 2009 and 2010 Petersen accrued expenses for wages, vacation pay, and
related payroll items (collectively, accrued payroll expenses) on behalf of its em-
ployees. Some of these accrued payroll expenses were not expected to be paid,
and were not in fact paid, until the year following the year in which Petersen made
the accruals. If Petersen and its employees were “related persons,” section 267(a)
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operated to defer the corporate deduction for these accrued but unpaid expenses--
and the resulting flowthrough deductions to petitioners as Petersen’s shareholders
--until the year the expenses were paid and the amounts were includible in the
employees’ income.
Section 267(e) provides “special rules for pass-thru entities,” including S
corporations. In the case of any amount paid or incurred by an S corporation, the
corporation and “any person who owns (directly or indirectly) any of the stock of
such corporation” are deemed to be “related persons” for purposes of section
267(b). See sec. 267(e)(1)(B)(ii). Section 267(c)(1), which sets forth rules for
constructive ownership of stock, provides that “[s]tock owned, directly or indi-
rectly, by or for a * * * trust shall be considered as being owned proportionately
by * * * its * * * beneficiaries.”
During 2009 and 2010 Petersen maintained an employee stock ownership
plan (ESOP) for its participating employees. During each year, some or all of the
Petersen stock was owned by the related ESOP trust. Respondent contends that
the ESOP trust is a “trust” within the meaning of section 267(c)(1), with the con-
sequence that the trust beneficiaries--viz., the Peterson employees who were ESOP
participants--are deemed to have owned their proportionate shares of the Petersen
stock held by the trust.
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In short, if Petersen’s employees were the beneficiaries of a trust that owned
Petersen stock, as respondent contends, they were deemed “related” to Petersen for
purposes of section 267(b). That would make section 267(a)(2) applicable to re-
quire that the company’s deductions for accrued but unpaid payroll expenses be
deferred until the pay was received by the employees and thus includible in their
gross income. We agree with respondent’s construction of the statute and will ac-
cordingly render a decision in his favor with respect to the deficiencies. But we
rule for petitioners on the penalties.
Background
These cases were submitted fully stipulated under Rule 122. There is no
dispute as to the following facts, which are drawn from the parties’ stipulations of
facts and the attached exhibits. Petitioners resided in Utah when they petitioned
this Court. Larue Johnstun is a party solely by virtue of having filed joint Federal
income tax returns with her husband.
Petersen was incorporated in Utah in 1980 and filed a subchapter S election
in 1989. In August 2001 the company formed an ESOP for the benefit of its em-
ployees and transferred cash and Petersen stock to the related ESOP trust. During
2009 and the first nine months of 2010 the ESOP trust owned 20.4% of the com-
pany; Mr. and Mrs. Petersen collectively owned 79.2%, and Mr. Johnstun owned
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0.4%. On October 1, 2010, the ESOP trust acquired petitioners’ shares and be-
came the company’s sole shareholder.
Petersen generally paid its employees every second Friday. At year-end
2009 and 2010 Petersen had accrued but unpaid wage expenses of $1,059,767 and
$825,185, respectively. These amounts were paid to its employees by January 31
of the following year. Approximately 89% of these amounts was attributable to
employees who participated in the ESOP.
Petersen’s employees accrued vacation time as they worked. They were re-
quired to use this accrued vacation time during the year accrued or during the next
calendar year. At year-end 2009 and 2010 Petersen had accrued but unpaid vaca-
tion pay expenses of $473,744 and $503,896, respectively. These amounts were
paid to its employees by December 31 of the following year. Roughly 94.5% of
these amounts was attributable to employees who participated in the ESOP.3
Petersen filed timely Forms 1120S, U.S. Income Tax Return for an S Cor-
poration, for 2009 and 2010. On these returns it claimed deductions for (among
other things) the accrued but unpaid payroll expenses described above. Petitioners
3
At year-end 2009 and 2010 Petersen had also accrued, but not yet paid to
its employees, “other” expenses of $34,986 and $21,302, respectively. The record
does not disclose the nature of these expenses or when they were ultimately paid.
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on their individual returns claimed flowthrough deductions equal to their pro rata
shares of these accrued but unpaid expenses.
The IRS selected Petersen’s 2009 and 2010 Forms 1120S for examination.
Invoking section 267, the IRS disallowed deductions for the accrued but unpaid
expenses to the extent they were attributable to employees who participated in the
ESOP. The IRS then performed a follow-on examination of petitioners’ individual
returns. For 2009 the IRS disallowed flowthrough deductions aggregating
$1,214,835 for Mr. and Mrs. Petersen and $6,338 for Mr. Johnstun. For 2010 the
IRS allowed additional flowthrough deductions aggregating $120,818 for Mr. and
Mrs. Petersen and $512 for Mr. Johnstun, attributable to certain expenses that had
been accrued in 2009 and paid in 2010. These allowances generated overpay-
ments for 2010. As a result of these determinations and computational adjust-
ments to petitioners’ itemized deductions for 2009, the IRS determined the defi-
ciencies and overpayments set forth above. See supra pp. 3-4. The IRS also deter-
mined accuracy-related penalties for 2009.
On February 10, 2015, we consolidated these cases for purposes of trial,
briefing, and opinion. On June 1, 2015, we granted the parties’ motion for leave
to submit the cases for decision without trial under Rule 122. On April 15, 2016,
we asked the parties to file a supplemental stipulation of facts and attach thereto
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copies of the ESOP’s trust instrument and other organizational documents. They
timely complied with this request.
Discussion
I. Accrued Expenses
Deductions are a matter of legislative grace, and the burden is on the tax-
payer to prove entitlement to claimed deductions. INDOPCO, Inc. v. Commis-
sioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435,
440 (1934). Petitioners do not contend that the burden of proof should shift to
respondent under section 7491. In any event, with respect to the deficiencies only
legal issues remain, so the burden of proof is irrelevant. See, e.g., Nis Family Tr.
v. Commissioner, 115 T.C. 523, 538 (2000).
Generally, an accrual basis taxpayer may deduct ordinary and necessary
business expenses in the year when all events have occurred that establish the fact
of the liability, the amount of the liability is set, and economic performance has
occurred with respect to the liability. Sec. 461; sec. 1.446-1(c)(1)(ii)(A), Income
Tax Regs. When such expenses are owed to a related cash basis taxpayer, how-
ever, section 267(a)(2) provides that the payor may deduct the expenses only for
the taxable year for which the amounts are includible in the payee’s gross income.
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See Tate & Lyle, Inc. v. Commissioner, 103 T.C. 656, 659 (1994), rev’d and re-
manded on other grounds, 87 F.3d 99 (3d Cir. 1996).
Petersen was an accrual basis taxpayer during 2009 and 2010, and the ESOP
participants were cash basis taxpayers. The parties agree that the accrued payroll
expenses were ordinary and necessary to the company’s business and that the re-
quirements of section 461 have been met. The sole issue is whether the company
and the ESOP participants were related persons under section 267(b).
A. Threshold Arguments
Petitioners advance three threshold arguments that we will address briefly.
First, they contend that section 318, not section 267, provides the applicable rules
for constructive ownership of stock.4 Section 318 is one of several Code provi-
sions that set forth rules for constructive ownership of stock. By its terms, how-
ever, it applies only “[f]or purposes of those provisions of this subchapter to which
the rules contained in this section are expressly made applicable.” Sec. 318(a).
Section 318 does not apply here for two reasons. First, section 318 is in
subchapter C, whereas section 267 is in subchapter B, of title 26, subtitle A,
4
Petitioners wish section 318 to apply because its attribution rule for trusts
excludes tax-exempt employees’ trusts. See sec. 318(a)(2)(B)(i) (“Stock owned,
directly or indirectly, by or for a trust (other than an employees’ trust described in
section 401(a) which is exempt from tax under section 501(a)) shall be considered
as owned by its beneficiaries[.]”).
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chapter 1. Thus, section 267 is not a “provision[] of this subchapter” within the
meaning of section 318(a). Second, the rules of section 318 are not “expressly
made applicable” by section 267. Quite the contrary: Section 267(c) provides its
own rules for constructive ownership of stock, demonstrating Congress’ intent that
these latter rules should apply. Cf. In re S. Beach Sec., Inc., 606 F.3d 366, 375
(7th Cir. 2010) (Posner, J.) (ruling that the attribution rules of section 318 “don’t
apply to section 269; for section 318 applies only when expressly made applicable
* * *, and it hasn’t been made expressly applicable to section 269, which anyway
is not in subchapter C”).
Petitioners cite Boise Cascade Corp. v. United States, 329 F.3d 751 (9th Cir.
2003), to support a contrary conclusion. The question there was whether pay-
ments by a corporation to redeem stock held by an ESOP trust were deductible as
“dividends paid” under section 404(k). The answer depended on whether the re-
demption was “not essentially equivalent to a dividend,” in which case it would be
treated under section 302(b)(1) as an “exchange” rather than a dividend. Applying
the constructive ownership rules of section 318, the Court of Appeals for the Ninth
Circuit concluded that the ESOP trust should be treated as the owner of the re-
deemed stock for purposes of section 302(b)(1); that the redemptions caused no
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meaningful reduction of its ownership interest; and hence that the redemptions
constituted “dividends” as the taxpayer contended.
Petitioners err in relying on Boise Cascade. The operative Code provision
there was section 302. Section 302 is part of subchapter C, and the rules of sec-
tion 318 are expressly made applicable to section 302. See sec. 302(c) (“[S]ection
318(a) shall apply in determining the ownership of stock for purposes of this sec-
tion.”). The operative Code provision here is section 267. As noted previously,
section 267 is not part of subchapter C, and the rules of section 318 are not (ex-
pressly or otherwise) made applicable to it.
Petitioners next contend that, because Petersen’s gross receipts exceed $5
million annually, section 448 requires that the company be an accrual basis tax-
payer. This contention is incorrect: Section 448 applies only to C corporations,
tax shelters, and partnerships with a C corporation as a partner. See sec. 448(a).
In any event, section 267(a) does not deny Petersen use of the accrual method
generally; it simply defers deductions for a limited universe of expenses payable to
related cash basis parties.
Third, petitioners urge that respondent’s position violates generally accept-
ed accounting principles (GAAP) by denying a current deduction for properly
accrued payroll costs. As has often been noted, however, tax accounting differs in
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many respects from GAAP financial accounting. See, e.g., United States v.
Hughes Props., Inc., 476 U.S. 593, 603 (1986); Thor Power Tool Co. v. Com-
missioner, 439 U.S. 522 (1979) (disallowing writedown of excess inventory for
tax purposes even though it conformed to GAAP); Hamilton Indus., Inc. v. Com-
missioner, 97 T.C. 120, 128 (1991). Especially is that so where (as here) a Code
provision explicitly requires a treatment that differs from GAAP. Petersen has no
greater claim than any other accrual basis taxpayer to exemption from the opera-
tion of section 267.
B. Statutory Background
Section 267 is designed “to prevent the use of the differing methods of
reporting income for Federal income tax purposes in order to obtain artificial
deductions for interest and business expenses.” Metzger Tr. v. Commissioner, 76
T.C. 42, 75 (1981), aff’d, 693 F.2d 459 (5th Cir. 1982). Originally enacted in
1934, the statute has been amended many times, most substantially in 1984. Defi-
cit Reduction Act of 1984, Pub. L. No. 98-369, sec. 174(c), 98 Stat. at 704-708.
Section 267 is remedial, requiring related persons to “use the same accounting
method with respect to transactions between themselves in order to prevent the
allowance of a deduction without the corresponding inclusion in income.” H.R.
Rept. No. 98-432 (Part 2), at 1578 (1984), 1984 U.S.C.C.A.N. 697, 1205.
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Section 267(b) generally defines the “relationships” that bring the statute
into play. Before 1978 transactions between S corporations and their shareholders
were exempt from its coverage unless the shareholder owned (constructively or
otherwise) more than 50% of the corporation’s stock. See sec. 267(b)(2). Con-
gress revised that treatment in 1978 by enacting section 267(e). Act of November
10, 1978, Pub. L. No. 95-628, sec. 2(a), 92 Stat. at 3627. Section 267(e) provides
that, for purposes of applying subsection (a)(2), an S corporation and “any person
who owns (directly or indirectly) any of the stock of such corporation” shall be
“treated as persons specified in a paragraph of subsection (b).” Section 267(e)
thus deems S corporations and their shareholders to be “related persons” regard-
less of how much or how little stock each shareholder individually owns.5
Section 267(c) provides constructive ownership rules “[f]or purposes of de-
termining, in applying subsection (b), the ownership of stock.” As noted previous-
ly, subsection (e)(1) provides that an S corporation and its shareholders “shall be
treated as persons specified in a paragraph of subsection (b).” See sec. 1.267(a)-
2T(b), Q&A-4 and -5, Temporary Income Tax Regs., 49 Fed. Reg. 46995 (Nov.
30, 1984) (referring to section 267(b) as “modified by section 267(e)”). Thus, the
5
Before it was amended by the Deficit Reduction Act of 1984, Pub. L. No.
98-369, sec. 174(c), 98 Stat. at 704-708, section 267(f) allowed an S corporation
to deduct accrued amounts before payout if the payee shareholder held less than a
2% interest in the corporation.
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constructive ownership rules of subsection (c) apply in determining the ownership
of Petersen’s stock.
As relevant here, section 267(c)(1) provides that “[s]tock owned, directly or
indirectly, by or for a corporation, partnership, estate, or trust shall be considered
as being owned proportionately by or for its shareholders, partners, or benefici-
aries.” Thus, if the ESOP participants by virtue of subsection (c) constructively
own Petersen stock as beneficiaries of a trust, subsection (e) deems the company
and those employees--no matter how small their percentage ownership--to be “re-
lated persons” for purposes of subsections (a) and (b). We turn now to that legal
question: whether the Petersen stock in question was owned, within the meaning
of section 267(c)(1), by a “trust” of which the ESOP participants were “bene-
ficiaries.”6
C. Analysis
“Our first step in interpreting a statute is to determine whether the language
at issue has a plain and unambiguous meaning.” Robinson v. Shell Oil Co., 519
6
Under the corporation/shareholder relationship defined in section
267(b)(2), the only ESOP participants deemed “related” to the company would be
Mr. and Mrs. Petersen, who collectively owned 79.2% of the Petersen stock until
October 1, 2010. However, section 267(e)(1)(B)(ii) supplements section 267(b),
in the case of S corporations, by providing that “any person” who owns construc-
tively or directly “any of the stock” of an S corporation “shall be treated as [a]
person[] specified in a paragraph of subsection (b).”
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U.S. 337, 340 (1997). In determining “the plain meaning of the statute, the court
must look to the particular statutory language at issue, as well as the language and
design of the statute as a whole.” K Mart Corp. v. Cartier, Inc., 486 U.S. 281, 291
(1988). We ordinarily give the words Congress used their ordinary meaning, un-
less doing so would produce absurd or futile results. United States v. Am. Truck-
ing Ass’ns, Inc., 310 U.S. 534, 543-544 (1940); see Tamarisk Country Club v.
Commissioner, 84 T.C. 756, 761 (1985). If a statute is clear on its face, we require
unequivocal evidence of legislative intent before construing the statute in a man-
ner that overrides the plain meaning of the words used therein. Halpern v. Com-
missioner, 96 T.C. 895, 899 (1991).
The term “trust” is not defined in section 267(c)(1) or elsewhere in section
267. Subsection (c)(1) was included in the original version of the statute as enact-
ed in 1954. Internal Revenue Code of 1954, ch. 736, sec. 267(c)(1), 68A Stat. at
79. Since then section 267 has been amended 11 times, but none of these amend-
ments changed the wording of subsection (c)(1) or provided a definition of “trust.”
The legislative history is likewise silent concerning the universe of entities that
Congress intended this term to encompass.
The word “trust” appears in section 267(c)(1) as part of series that also in-
cludes “corporation,” “partnership,” and “estate.” Each of these words appears to
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be used in a broad and generic sense without limitation or qualification. In this
respect section 267 differs in a critical way from section 318, which prescribes
constructive ownership rules for certain provisions of subchapter C. Section
318(a)(2)(B)(i) mandates attribution to beneficiaries of stock owned “by or for a
trust (other than an employees’ trust described in section 401(a) which is exempt
from tax under section 501(a)).” This provision shows that Congress knew how to
limit the scope of the term “trust” when it intended to do so. It expressed no such
intent in section 267 or in the legislative history accompanying the statute’s enact-
ment and amendment.
In determining whether the Petersen stock was owned by a “trust” as that
term is ordinarily understood, we begin by examining the documents that created
the ESOP. When Petersen adopted the ESOP in 2001, two documents were draft-
ed: a plan agreement and a trust instrument. The plan agreement states that the
ESOP is “intended to be an employee stock ownership plan within the meaning of
section 4975(e)(7).” Section 1.3 provides that amounts contributed to the ESOP
are held by a “trustee” who acts in accordance with the terms of a trust instrument.
That section further provides that “[t]he Trust implements and forms a part of the
Plan” and that “[t]he provisions of and benefits under the Plan are subject to the
terms and provisions of the Trust.”
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The plan agreement specifies the ESOP participants’ rights and the trustee’s
duties with regard to holding, investing, and distributing the plan’s assets subject
to the direction of the plan administrator. Section 14 requires the plan administra-
tor as a fiduciary to discharge his or her duties “with respect to the Plan and the
Trust solely in the interests of Participants.” Section 7.1 provides that an indi-
vidual account shall be created in the name of each participant, and section 1.3
provides that the amounts in these accounts are held and invested by the trustee.
The trust instrument is titled “Petersen, Inc. Employee Stock Ownership
Trust.” Article 2 specifies how the trust assets--chiefly Petersen stock--are to be
managed and controlled. It states that the trustee is required to: (1) manage and
account for all contributions that Petersen makes under the Plan “as one Trust
Fund”; (2) receive and hold “all contributions paid to it under the Plan”; (3) retain
sufficient cash “as may be required for the proper administration of the Trust”;
(4) “make distributions from the Trust Fund”; (5) “vote any stocks * * * held in
the Trust”; (6) “furnish to the Company and the Administrator an annual written
account”; and (7) “invest and reinvest the assets of the Trust Fund, upon direction
from the Administrator.” The trust agreement requires the trustee to discharge
these duties “solely in the interest of the Plan’s participants” with the “care, skill,
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prudence, and diligence under the circumstances then prevailing that a prudent
person acting in a like capacity * * * would use.”
Article 4.3 of the trust instrument provides that interests under the Plan are
not subject to the claims of Petersen’s creditors “and may not be voluntarily or in-
voluntarily assigned.” Article 5, captioned “No Reversion to Company,” provides
that “no part of the corpus or income of the Trust Fund” shall revert to Petersen,
provided that Petersen’s initial contribution may be returned to it if the ESOP
should initially fail to qualify under section 401(a).7
These provisions show that the entity holding the Petersen stock for the
benefit of the ESOP participants was a “trust” in the ordinary sense of that word.
The regulations describe a trust as an arrangement “whereby trustees take title to
property for the purpose of protecting or conserving it for the beneficiaries.” Sec.
301.7701-4(a), Proced. & Admin. Regs. “Generally speaking, an arrangement will
be treated as a trust * * * if it can be shown that the purpose of the arrangement is
7
Consistently with the plan agreement and the trust instrument, the “Sum-
mary Plan Description” furnished to the ESOP participants states that “under the
ESOP, stock representing your beneficial ownership in the Company will be held
on your behalf” in “a special trust called an employee stock ownership trust. The
trust is part of the ESOP.” This document lends further support to the conclusion
that Petersen intended to establish and actually did establish a trust to hold its
stock for the benefit of its employees.
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to vest in trustees responsibility for the protection and conservation of property for
beneficiaries.” Ibid.8
The arrangement involved here closely resembles an ordinary trust whereby
a settlor (here, the company) establishes a trust for the benefit of specified bene-
ficiaries (the ESOP participants), contributes property to the trust (Petersen stock
and cash), and designates a trustee to hold the property for the beneficiaries and
act in their best interest. The ESOP trust easily qualifies as a “trust” under the
regulatory definition and the common law definitions appearing in the case law.9
8
In contrast, a “business trust”--viz., an entity created to allow a beneficiary
to carry on an income-producing activity that would otherwise have been con-
ducted through a corporation or partnership--is not treated as a “trust” for Federal
income tax purposes because there are no arrangements to protect or conserve
property for beneficiaries. Sec. 301.7701-4(b), Proced. & Admin. Regs.
9
See, e.g., Cent. States, Se. and Sw. Areas Pension Fund v. Cent. Transp.,
Inc., 472 U.S. 559 (1985) (holding that a trust is generally denoted by the vesting
of duties in a trustee, including a duty to preserve and maintain trust assets);
Owner Operator Indep. Drivers Ass’n, Inc. v. Comerica Bank (In re Arctic Express
Inc.), 636 F.3d 781, 792 (6th Cir. 2011) (citing Restatement (Third) of Trusts for
common law definition of a “trust”); United States v. De Bonchamps, 278 F.2d
127, 133 (9th Cir. 1960) (holding that a relationship is generally classified as a
trust if it is “clothed with the characteristics of a trust”); Hart v. Commissioner, 54
F.2d 848, 850-851 (1st Cir. 1932), rev’g in part 21 B.T.A. 1001 (1930); Johnson v.
Commissioner, 108 T.C. 448, 475 (1997), aff’d in part, rev’d in part on other
grounds, 184 F.3d 786 (8th Cir. 1999); George Gleason Bogert, et al., Bogert’s
Trusts and Trustees, sec. 582 (2016).
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Indeed, if the plan assets were not held by a “trust,” the ESOP could not
qualify under ERISA. See 29 U.S.C. sec. 1103(a) (2012) (“[A]ll assets of an em-
ployee benefit plan shall be held in trust by one or more trustees.”). Section
401(a), in conjunction with section 501(a), supplies the tax exemption for all qual-
ified plans, including ESOPs. It provides that a “trust created or organized in the
United States and forming part of a stock bonus * * * plan of an employer * * *
shall constitute a qualified trust” if (among other things) contributions are made to
the trust for the benefit of plan participants. Section 4975(e)(1)(A) defines a
“plan” to include “a trust described in section 401(a) which forms a part of a
plan.” Section 4975(e)(7) defines an ESOP as a “defined contribution plan * * *
which is a stock bonus plan” that is “qualified * * * under section 401(a)” and
meets the requirements of section 409. And section 404(a)(3)(A)(i) allows the
employer a deduction (subject to specified dollar limits) “if the contributions are
paid into a stock bonus or profit-sharing trust.” In short, the statutory scheme
upon which the ESOP arrangement rests presumes that the stock held for the
benefit of the ESOP participants will be owned by a “trust.”
Petitioners advance in support of a contrary conclusion a variety of argu-
ments, which may be divided into two groups. The thrust of the first group is that
the ESOP documents do not show that Petersen intended to create a trust:
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• Petitioners contend that Petersen’s right to terminate the plan gives it a re-
versionary interest that is inconsistent with the premise of a trust, namely, that the
trust assets are held for its beneficiaries. Petitioners are correct that Petersen in
specified circumstances can terminate the plan. But their argument ignores section
8.2 of the trust instrument, which requires, in the event of plan termination, that
the trust fund be liquidated and distributed to the ESOP participants (subject to a
reserve for paying the trustee’s expenses). Indeed, if Petersen held a reversionary
interest in the trust assets, the ESOP could not qualify for tax exemption. See sec.
1.401-2(a)(1), Income Tax Regs. (“[A] trust is not qualified unless under the trust
instrument it is impossible * * * for any part of the trust corpus or income to be
used for, or diverted to, purposes other than for the exclusive benefit of such em-
ployees and their beneficiaries.”).
• Petitioners contend that the plan agreement takes precedence over the trust
instrument because the trustee will typically act on instructions from the plan ad-
ministrator. While the latter statement may be true, we do not see how it affects
the proper characterization of the entity owning the assets. The trust instrument
explicitly requires the trustee to hold and protect the assets for the beneficiaries
and to discharge his fiduciary duties for their exclusive benefit. The fact that the
trustee accepts instructions from the plan administrator regarding investment
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decisions and other matters does not alter his status as a trustee or cause the trust
to be something other than a trust.
• The plan agreement states that, “[t]o the extent not superseded by the laws
of the United States, the laws of Utah shall be controlling in all matters relating to
the Plan.” Petitioners contend that Utah law excludes from the definition of
“trust” a plan established for the primary purpose of providing employee benefits
and that Utah law should control this question. But it is well settled that the inter-
pretation of terms employed in the Internal Revenue Code is governed by Federal,
not State, law. See, e.g., Commissioner v. Tower, 327 U.S. 280, 288 (1946); Ken-
field v. United States, 783 F.2d 966, 969 (10th Cir. 1986); Killoran v. Commis-
sioner, 709 F.2d 31, 31-32 (9th Cir. 1983), aff’g T.C. Memo. 1981-659, 42 T.C.M.
(CCH) 1662. The central question presented by these cases--the meaning and
scope of the term “trust” as used in section 267(c)(1)--is a question of Federal law
because it involves the proper interpretation of a Federal statute. On this point
Utah law is “superseded by the laws of the United States.”
The thrust of petitioners’ second group of arguments is that an ESOP, as a
matter of law, cannot be a “trust” within the meaning of section 267(c)(1). These
arguments share a common flaw: They fail to appreciate the distinction between
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the plan agreement, which created the ESOP, and the trust instrument, which cre-
ated the trust that holds the plan assets. We will address these arguments briefly:
• Petitioners contend that an ESOP is not a trust and that the Petersen ESOP
has “participants” rather than “beneficiaries” of the sort covered by section
267(c)(1). This argument fails because the trust that holds the assets is distinct
from the plan that created the ESOP. See sec. 401(a) (referring to “[a] trust * * *
forming part of a stock bonus * * * plan”); sec. 401(a)(28)(A) (referring to “a trust
which is part of an employee stock ownership plan”); sec. 4975(e)(7) (defining an
ESOP as a “stock bonus plan which is qualified * * * under section 401(a)”). This
is not an “either/or” dilemma: Petersen’s employees are simultaneously partici-
pants in the plan and beneficiaries of the trust.
• Petitioners contend that ESOPs are subject only to the provisions of sub-
chapter D (governing retirement and other qualified plans) and hence are immune
from the operation of subchapter B (governing computation of taxable income),
which includes section 267. This is clearly incorrect because the provisions of
subchapter B apply to countless entities and relationships in the Code, regardless
of which subchapter addresses their taxation in particular. The constructive own-
ership rules of section 267(c), for example, explicitly apply to partnerships (whose
taxation is governed by subchapter K) and estates (whose taxation is governed by
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subchapter J). In any event, respondent seeks to apply section 267, not to compute
the ESOP’s taxable income, but to compute Petersen’s allowable deductions that
flow through to petitioners. Petitioners and Petersen are clearly subject to sub-
chapter B.
• Petitioners note that ESOPs did not exist under common law and contend
that the term “trust” as used in section 267(c)(1) should be limited to common law
trusts subject to subchapter J (governing the taxation of estates, trusts, and their
beneficiaries). The fact that ESOPs are creatures of statute rather than common
law is irrelevant. The question at hand is whether an inter vivos trust created in
connection with an ESOP is a “trust” within the meaning of the statute.
The regulations define a “trust” as “an arrangement created either by * * *
will or by * * * inter vivos declaration whereby trustees take title to property for
the purpose of protecting or conserving it for the beneficiaries.” Sec. 301.7701-
4(a), Proced. & Admin. Regs. The ESOP trust meets that definition, and petition-
ers have offered no persuasive reason for giving the term “trust” as it appears in
section 267(c)(1) a more restrictive meaning. Had Congress wished to limit the
statute’s application to trusts and beneficiaries whose taxation is governed by
subchapter J, it could easily have drafted section 267(c)(1) to say so. Cf. sec.
318(a)(2)(B)(i) (prescribing attribution to beneficiaries of stock owned “by or for a
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trust (other than an employees’ trust described in section 401(a) which is exempt
from tax under section 501(a))”).
• Finally, petitioners appear to contend that the ESOP trust, because it is
integrated with and supposedly “subservient” to the plan, has no separate exist-
ence for Federal tax purposes and is thus immune from the coverage of section
267. This argument misapprehends the statutory structure on which the ESOP’s
tax exemption rests. Although the ESOP trust was formed as part of the plan, it is
(and must be) a legally distinct entity created by a distinct trust instrument. See,
e.g., sec. 401(a)(28)(A) (referring to “a trust which is part of an employee stock
ownership plan”); sec. 404(a)(3)(A)(i) (allowing the employer a deduction “if the
contributions are paid into a stock bonus or profit-sharing trust”); 29 U.S.C. sec.
1103(a) (“[A]ll assets of an employee benefit plan shall be held in trust by one or
more trustees.”).
At the end of the day, petitioners’ core complaint is that Congress did not
exclude tax-exempt employee trusts from the constructive ownership rules of sec-
tion 267(c), as it explicitly did from the constructive ownership rules of section
318(a). Conceivably this was a drafting oversight: When Congress in 1978 en-
acted section 267(e) to address the treatment of S corporations and their share-
holders, ESOPs were not eligible to be S corporation shareholders. See Small
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Business Job Protection Act of 1996, Pub. L. No. 104-188, sec. 1316, 110 Stat. at
1785-1786 (enacting section 1361(c)(7) with an effective date of January 1, 1998).
See generally Austin v. Commissioner, T.C. Memo. 2017-69. In any event, we are
bound by the law that Congress enacted; we are not at liberty to revise section
267(c) to craft an exemption that Congress did not see fit to create. See Metzger
Trust, 76 T.C. at 59 (“Courts do not have the power to repeal or amend the enact-
ments of the legislature.”).
In sum, we conclude that the “Petersen, Inc. Employee Stock Ownership
Trust” is a “trust” within the meaning of section 267(c)(1). Congress did not limit
the universe of trusts to which that provision applies; it could easily have drafted
section 267(c)(1), as it drafted section 318(a)(2)(B)(i), to exclude tax-exempt em-
ployee trusts, but it did not do so. The trust formed in connection with the Peter-
sen ESOP was created by a trust instrument; it has all the features of a trust in the
ordinary sense of the word; and it was required to be a trust under the statutory
structure on which the ESOP’s tax exemption rests.
Section 267(c)(1) thus deems the Petersen stock held by the trust to be
owned by the trust’s beneficiaries, viz., the Petersen employees who participated
in the ESOP. As a result the ESOP participants and the company are deemed
“related persons” for purposes of section 267(b). See sec. 267(e)(1)(B)(ii). Sec-
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tion 267(a) accordingly operates to defer Petersen’s deductions for the accrued but
unpaid payroll expenses to the year in which such pay was received by the ESOP
participants and includible in their gross income.
II. Penalties
The Code imposes a 20% penalty on the portion of any underpayment of tax
attributable to “[n]egligence or disregard of rules and regulations” or “[a]ny sub-
stantial understatement of income tax.” Sec. 6662(a) and (b)(1) and (2). Negli-
gence includes “any failure to make a reasonable attempt to comply” with the in-
ternal revenue laws. Sec. 6662(c). An understatement of income tax is “sub-
stantial” if it exceeds the greater of $5,000 or 10% of the tax required to be shown
on the return. Sec. 6662(d)(1)(A). Under section 7491(c) respondent bears the
burden of production with respect to the liability of an individual for any penalty.
See Higbee v. Commissioner, 116 T.C. 438, 446 (2001).
No penalty is imposed with respect to any portion of an understatement if
the taxpayer acted with reasonable cause and in good faith with respect thereto.
The taxpayer bears the burden of proving reasonable cause and good faith. Id. at
446-447. The determination of whether a taxpayer acted with reasonable cause
and in good faith is made on a case-by-case basis, taking into account all the facts
and circumstances, the most important of which is the extent of the taxpayer’s
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effort to assess his proper tax liability for the year. Sec. 1.6664-4(b)(1), Income
Tax Regs. Circumstances that indicate reasonable cause and good faith include an
honest misunderstanding of law that is reasonable in light of all the surrounding
facts. Id.
We conclude that petitioners made a good-faith effort to assess their tax
liabilities properly and hence are not liable for any accuracy-related penalty. The
application of section 267(a) to employers and ESOP participants is a question of
first impression in this Court; we have discovered no prior case addressing this
question, and respondent has pointed us to none. We have previously declined to
impose a penalty “where it appeared that the issue was one not previously consid-
ered by the Court and the statutory language was not entirely clear.” See Hitchins
v. Commissioner, 103 T.C. 711, 719-720 (1994). Because petitioners acted
reasonably and in good faith with respect to the understatements for the years at
issue, we find that they are not liable for penalties under section 6662(a).
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To reflect the foregoing,
Decisions will be entered for
respondent with respect to the deficiencies
and for petitioners with respect to the
penalties.