dissenting: I respectfully disagree with the majority’s opinion to the extent it finds that the prohibited transaction has not been “corrected” within the meaning of section 4975(f)(5).
Petitioners are husband and wife who had owned and farmed 1,205 acres located in extreme western North Dakota in a barren, sparsely populated area in the foothills of the Badlands. In the 1970s, oil was discovered on their property. After the discovery of oil, petitioners entered into mineral lease arrangements with Gulf Oil Corp. in 1977.
In May 1981, when petitioner Anton was 61, petitioners incorporated their farming operations. The corporation simultaneously adopted an employee stock ownership plan (hereinafter referred to as the ESOP). At the same time, petitioners sold their real estate consisting of the 1,205 acres including mineral rights to the ESOP for an annuity worth $6,481,915. On the date of sale, the fair market value of the 1,205 acres was $6,481,915. The value of this real estate was allocable to its use as farmland in the amount of $361,500 and to mineral rights in the amount of $6,120,415. Prior to entering into these transactions, petitioners consulted with professional advisers who determined that the sale of petitioners’ farmland to the ESOP was not a prohibited transaction which would give rise to excise tax under section 4975.
At the time petitioners sold their farmland to the ESOP, they were the only beneficiaries of the ESOP. For approximately 2 years after the sale, petitioners remained the only beneficiaries of the ESOP. On April 30, 1983, petitioners terminated their employment with their farming corporation and forfeited their entire interest in the ESOP. (Petitioner Anton’s rights in the ESOP would have become 100-percent vested in December 1984.) At approximately the same time, petitioners’ three sons became employees of the farming corporation and beneficiaries of the ESOP. Shortly thereafter, petitioners’ three daughters also became beneficiaries of the ESOP. Thereafter, all six of petitioners’ children shared equally as the only beneficiaries of the ESOP.
As of December 31, 1981, the ESOP had received $703,559.32 in royalty income as a result of owning the real estate. As of April 30, 1982, there had been only $1,500 contributed to the ESOP as employer contributions. However, the real estate had maintained its value and had also produced in excess of $1.3 million in royalty income resulting in a net asset value of the ESOP of $718,121.57. As of April 30, 1983, there was still only $1,500 in employer contributions to the ESOP, the real estate had maintained its value, royalty income for the year had been over $2 million, and the net asset value of the ESOP was then $2,927,787.93. On April 30, 1986, the value of the real estate was greater than the original purchase price, gross royalty income for the prior 5-year period totaled over $9 million and the net asset value of the ESOP was $5,287,349.27. As of April 30, 1986, cumulative employer contributions for the prior 5-year period totaled only $12,900. To say that the prohibited transaction was beneficial to the ESOP and its beneficiaries would be a gross understatement.
The majority finds that each petitioner is liable for the 5 percent excise tax provided for by section 4975(a) for each of 6 taxable years in an amount of $324,095.75 per year. In addition, because the majority finds that there has been no “correction” within the taxable period, it also determines that the excise tax pursuant to section 4975(b) is applicable and that each petitioner is liable for the second-tier tax in the amount of $6,481,915. Given the particular facts in this case, this result is draconian and, in my opinion, is not required by either the statute or the regulations and produces a result that is contrary to the purpose of the statute. Because I believe a “correction” occurred in the first taxable year, I would hold that petitioners are only liable for the 5-percent first-tier tax for the initial year in which the prohibited transaction occurred.
The purpose of the two-tiered excise tax imposed by section 4975 is to protect the interests of the beneficiaries of plans from being jeopardized by transactions between the plan and a disqualified person. Rutland v. Commissioner, 89 T.C. 1137, 1146 (1987); H. Rept. 93-1280 (Conf.) (1974), 1974-3 C.B. 415, 483; S. Rept. 93-383 (1973), 1974-3 C.B. (Supp.) 80, 111, 173-174. Section 4975(a) provides for a mandatory first-tier tax equal to 5 percent of the amount involved with respect to the prohibited transaction. Rutland v. Commissioner, supra at 1143. A failure to “correct” the prohibited transaction within the first taxable year in which the prohibited transaction takes place results in imposition of an additional 5-percent tax for each subsequent taxable year until there is a “correction.” If a “correction” is not made prior to the notice of deficiency, the second-tier 100-percent tax is imposed.
Respondent does not dispute that the prohibited transaction was beneficial to the ESOP and its beneficiaries. Respondent argues, however, that Congress intended absolutely to prohibit such transactions; and the mere fact that the transaction was favorable to the ESOP and its beneficiaries does not eliminate application of section 4975. I agree that section 4975(a) automatically applies to a prohibited transaction regardless of whether it benefits the ESOP or was motivated by good intentions and that section 4975 was intended to provide a bright-line test to prohibit any transactions between an ESOP and a disqualified person. Donovan v. Cunningham, 716 F.2d 1455, 1464-1465 (5th Cir. 1983); Rutland v. Commissioner, supra at 1146. Petitioners’ argument that the instant prohibited transaction immediately self-corrected eliminating any tax under section 4975(a) is therefore without merit. The tax is predicated upon the prohibited transaction which unquestionably took place.
Congress, however, created provisions for the elimination of the first-tier tax for subsequent taxable years, and also for elimination of the second-tier tax, if there is a correction of the prohibited transaction. Sec. 4975(a), (f). I believe that the particular facts and circumstances in this case show that a “correction,” within the meaning of section 4975(f)(5), took place prior to the end of the first taxable year in which the prohibited transaction took place.
Section 4975(f)(5) defines correction as follows:
(5) Correction. — The terms “correction” and “correct” mean, with respect to a prohibited transaction, undoing the transaction to the extent possible, but in any case placing the plan in a financial position not worse than that in which it would be if the disqualified person were acting under the highest fiduciary standards. [Sec. 4975(f)(5). Emphasis added.]
Respondent’s regulations under section 4975 concerning “correction” refer to section 53.4941(e)-l(c), Foundation Excise Tax Regs., which provides that “Correction shall be accomplished by undoing the transaction which constituted the act of self-dealing to the extent possible.” (Emphasis added.) Section 53.4941(e)-l(c)(3)(i), Foundation Excise Tax Regs., provides: “In the case of a sale of property to a private foundation by a disqualified person for cash, undoing the transaction includes, but is not limited to, requiring rescission of the sale where possible.” (Emphasis added.) Respondent’s regulations specifically recognize one situation where a correction can be accomplished without any affirmative action to undo the transaction. Section 53.4941(e)-l(c)(3)(ii), Foundation Excise Tax Regs., recognizes that if the plan sells the property to a third party at a price that is greater than either the fair market value of the property on the date of the prohibited transaction or the amount paid to the disqualified person, and the plan’s income from the property during the plan’s ownership exceeds the income earned from the cash received by the disqualified person, a “correction” will be deemed to have occurred.1 “This portion of the regulation merely provides a practical exception to the general rule of rescission.” Leib v. Commissioner, 88 T.C. 1474, 1485 (1987). (Emphasis added.)2
The majority states that the statute and regulations clearly look to some affirmative act to effect correction. I agree that this is generally true. However, as explained above, the statute and regulations have no such literal requirement and recognize that undoing the transaction may not be possible. The regulations set forth a specific situation where a correction can occur even though no affirmative corrective action is taken by the disqualified person. The question is whether there are other situations where undoing the transaction is not possible within the meaning of the statute and whether correction can be effected without an affirmative act. The majority appears to answer in the negative by adopting respondent’s position that, absent physical impossibility (i.e., the property is not within the control of either party to the original prohibited transaction), there must be affirmative action to undo the transaction.3
The only mandatory requirement for correction is that the post correction financial status of the plan be no worse than if the disqualified person were acting under the highest fiduciary standards. Sec. 4975(f)(5). Neither the majority nor respondent seems to question that this specific mandatory requirement was met. Thus, I think resolution of the issue turns on what Congress intended when it required that the prohibited transaction be undone “to the extent possible.”
The term “possible” can encompass all that is capable of occurring without regard to rational limitations. However, the term “possible” can have a more limited meaning. “It is also sometimes equivalent to ‘practicable’ or ‘reasonable,’ as in some cases where action is required to be taken ‘as soon as possible.’ ” Black’s Law Dictionary 1166 (6th ed. 1990). I think it is clear that Congress used the term “possible” in this latter sense. Surely, Congress did not intend to require undoing a transaction without regard to the moral, ethical, legal, and rational consequences.
Petitioners, upon whom the majority would impose these extremely harsh results, were the very people whom the statute was intended to protect — the beneficiaries of the ESOP. Petitioners continued to be the only beneficiaries of the ESOP for approximately 2 years after the transaction. During that time the net asset value of the ESOP increased by over $2 million even though only $1,500 had been contributed to it. The only source for this dramatic increase in value was the asset transferred in the prohibited transaction. Not only were the beneficiaries’ interests safeguarded, they were substantially enhanced as a result of the transaction.4 Once this became clear, nothing salutary could be accomplished by undoing the transaction under these unique circumstances.5 The statutory objective of safeguarding the rights of the ESOP beneficiaries was achieved prior to December 31, 1981, and it was no longer rational to require a rescission.
On April 30, 1983, petitioners terminated their employment thereby forfeiting their interest in the ESOP, and thereafter their children became the only beneficiaries of the ESOP. The pecuniary benefits accruing to these beneficiaries continued to increase, again, all because of the beneficial nature of the prohibited transaction.
Respondent insists that the facts in this case require a rescission. Respondent’s legal position on brief is that the statute and regulations require petitioners to repurchase the property from the plan at its current value no matter how much it has increased in value. This could result in a financial disaster.6 Respondent argues, nevertheless, that petitioners’ failure to repurchase the property results in imposition of both the first- and second-tier tax.7
In Deluxe Check Printers, Inc. v. United States, 14 Cl. Ct. 782 (1988), revd. on other grounds sub nom. Deluxe Corp. v. United States, 885 F.2d 848 (Fed. Cir. 1989), the Claims Court recently rejected the Government’s position that a “correction” within the meaning of section 4941(e) required the rescission of a self-dealing transaction. After rejecting the Government’s argument, the Claims Court considered the taxpayer’s argument that a correction occurred because the prohibited transaction was favorable to the private foundation. The Claims Court, however, found as a fact that the original transaction was not favorable because the foundation received less than fair market value for the stock which it had sold in the prohibited transaction. However, the court then found that a correction had occurred when the foundation was subsequently paid the difference. Deluxe Check Printers, Inc. v. United States, supra. The court found that the prohibited transaction was corrected when the foundation was fully compensated. Had the Claims Court found that the foundation received full value initially, there would have been no difference to make up and, arguably, the court would have found that the prohibited transaction had been corrected immediately under the particular facts in that case. (The definition of what constitutes a “correction” in section 4941(e)(3) is the same as that in section 4975(f)(5).) In the instant case, there is no question that petitioners and the plan engaged in a transaction wherein each received fair market value and that the transaction resulted in favorable results for the plan.8
Another indication that Congress intended to achieve commonsense results so long as the plan and its beneficiaries are protected is reflected in section 4975(c)(2), which provides that the Secretary shall establish an exemption procedure to exempt what would otherwise be prohibited transactions from the first- and second-tier tax. The section gives guidance on what should be considered in granting an exemption by requiring that an exemption not be granted unless the Secretary finds it to be—
(A) administratively feasible,
(B) in the interests of the plan and of its participants and beneficiaries, and
(C) protective of the rights of participants and beneficiaries of the plan.
[Sec. 4975(c)(2).]
Pursuant to this statutory provision, respondent promulgated Rev. Proc. 75-26, 1975-1 C.B. 722, wherein exemption procedures are established.
Still another indication that Congress intended that the statute be applied in a commonsense manner to avoid draconian results is contained in 29 U.S.C. sec. 1203(a) (1990)9 wherein it gave “the Secretary of the Treasury * * * authority to waive the imposition of the tax imposed under section 4975(b) [26 U.S.C. sec. 4975(b)] in appropriate cases.”
It would appear that petitioners could have met the requirements for exemption in Rev. Proc. 75-26, 1975-1 C.B. 722. The majority seems to agree when it states: “We note, as does respondent, that petitioners could have avoided this litigation through a successful application for a special exemption pursuant to section 4975(c)(2). * * * Apparently, petitioners did not avail themselves of this exemption procedure, and cannot now seek its protection.” Majority op. p. 398. It should be pointed out, however, that respondent’s revenue procedure specifically provides that its provisions “may be initiated by either Secretary [Treasury or Labor] on his own motion.” Rev. Proc. 75-26, sec. 3.01, 1975-1 C.B. 722. Given the particular facts in this case and the explanation by the examining revenue agent of what he would have accepted as a correction, it would seem to have been more rational for respondent to have initiated a special exemption pursuant to the revenue procedure, thereby fully protecting the interests of the beneficiaries and avoiding an unnecessarily harsh result.
Congress did not specify in detail what is required for a correction; neither did Congress specifically preclude a finding that there was a correction under the facts in this case. In Deluxe Corp. v. United States, 885 F.2d 848 (Fed. Cir. 1989), revg. Deluxe Check Printers, Inc. v. United States, 14 Cl. Ct. 782 (1988), the issue was whether the excise tax under section 4941 on self-dealing transactions applied. A literal reading of the statute led the lower court to hold that the tax applied although the statute did not specifically preclude the taxpayer’s interpretation. The Federal Circuit reversed, finding that the lower court’s interpretation of the statute did not further the purpose of the statute which, was to protect private foundations. The court stated:
In this matter of statutory interpretation, where the text itself does not clearly exclude alternate interpretations, we look first to the legislative history for illumination of the intent of Congress. See, e.g., Shriners Hospitals for Crippled Children v. United States, 862 F.2d 1561, 1563 (Fed. Cir. 1988) (consulting legislative history).
*******
The absence of detail from a statutory text, or Congressional reluctance, to legislate for all possible future situations, does not mean that Congress thereby intended to adopt a policy intolerant of adaptive interpretation. It is still the original intent of Congress, as gleaned from the official history and accompanying explanation, to which we look in the first instance. * * *
[Deluxe Corp. v. United States, 885 F.2d at 850-851.]
I would find that the initial prohibited transaction was subject to the first-tier 5-percent excise tax. I would further find that there was a “correction” of that transaction because by the end of the first taxable year, the financial interest of the plan beneficiaries was protected beyond any requirements contained in section 4975(f)(5), and it was not rational to rescind the transaction in order to accomplish the objective of the statute, which is to protect the beneficiaries. The extent to which it is rationally possible to undo or rescind is dependent on all of the facts and circumstances. The unique facts in this case, including the substantial benefit to the plan beneficiaries and the fact that this harsh tax and the costs of undoing the transaction would fall on the very people whose interest the tax was intended to protect, make it irrational to require that the transaction be undone. “Statutes should be interpreted to avoid untenable distinctions and unreasonable results whenever possible.” American Tobacco Co. v. Patterson, 456 U.S. 63, 71 (1982); Deluxe Corp. v. United States, 885 F.2d 848 (Fed. Cir. 1989).
Kórner, Swift, Parr, and Colvin, JJ., agree with this dissenting opinion.Neither party raises the possibility that the ESOP might be considered to have resold part of the property involved in the prohibited transaction within the meaning of sec. 53.4941(e)-l(c)(3)(ii), Foundation Excise Tax Regs. The fair market value of the property on the date of the prohibited transaction was allocable as follows:
Farmland Mineral rights
$361,500. $6,120,415
(5.58%). (94.42%)
The majority opinion pp. 393-394 seems to rely on the fact that the surface rights and mineral rights are two separate types of property. Considering the fact that from Apr. 30, 1981, to April 30, 1986, the ESOP reported $9,226,896.58 in royalty income, it might be argued that property, consisting of the minerals in place, which was acquired in the prohibited transaction, had been sold by the ESOP thereby bringing the instant case within the literal terms of sec. 53.4941(e)-l(c)(3)(ii), Foundation Excise Tax Regs.
Sec. 53.4941(e)-l(c)(3)(i) and (ii), Foundation Excise Tax Regs., provides:
(3) Sales to foundation, (i) In the case of a sale of property to a private foundation by a disqualified person for cash, undoing the transaction includes, but is not limited to, requiring rescission of the sale where possible. However, in order to avoid placing the foundation in a position worse than that in which it would be if rescission were not required, the amount received from the disqualified person pursuant to the rescission shall be the greatest of the cash paid to the disqualified person, the fair market value of the property at the time of the original sale, or the fair market value of the property at the time of rescission. In addition to rescission, the disqualified person is required to pay over to the private foundation any net profits he realized after the original sale with respect to the consideration he received from the sale. Thus, for example, the disqualified person must pay over to the foundation any income derived by him from the cash he received from the original sale to the extent such income during the correction period exceeds the income derived by the foundation during the correction period from the property which the disqualified person originally transferred to the foundation.
(ii) If, prior to the end of the correction period, the foundation resells the property in an arm’s-length transaction to a bona fide purchaser who is not a disqualified person, no rescission is required. In such case, the disqualified person must pay over to the foundation the excess (if any) of the amount which would have been received from the disqualified person pursuant to subdivision (i) of this subparagraph if rescission had been required over the amount realized by the foundation upon resale of the property. In addition, the disqualified person is required to pay over to the foundation any net profits he realized, as described in subdivision (i) of this subparagraph.
The majority opinion, p. 400, note 10, cites several cases for support. Those cases may appear, at first blush, to support the majority. I believe each is distinguishable.
In Rutland v. Commissioner, 89 T.C. 1137 (1987), the Court again required the undoing of a prohibited transaction before we would recognize that a correction had taken place. As in Leib, the taxpayers argued that they had corrected the transaction on an earlier date but they were unable to prove that their attempted rescission had fully protected the interests of the plan beneficiaries.
In Leib v. Commissioner, 88 T.C. 1474 (1987), we rejected the taxpayers’ arguments that the regulation defining the correction requirements was invalid. The taxpayers in Leib had clearly sold property to their plan at an inflated price and were required to compensate the plan in order to effect a correction.
In Lambos v. Commissioner, 88 T.C. 1440 (1987), the issue was whether the prohibited transaction was statutorily exempt. There was no controversy or discussion about the legal requirements for a correction within the meaning of sec. 4975(f)(5). Lambos v. Commissioner, supra at 1445 n.3.
Finally, in the more recent case of Kadivar v. Commissioner, T.C. Memo. 1989-404 (not referred to by the majority), we determined that the taxpayer was liable for the sec. 4975 taxes for a prohibited transaction wherein he had borrowed money from the plan. We found that no correction had been made because the taxpayer had clearly not repaid the principal and interest. The interests of the plan beneficiaries clearly had not been safeguarded.
Each of the three cases that deal with the “correction” issue is also distinguishable because at the time of the prohibited transactions there were plan beneficiaries other than the persons against whom the sec. 4975 taxes were determined.
When questioned at trial about the effect of the prohibited transaction, respondent’s agent admitted that it was beneficial to the ESOP and its beneficiaries:
Q. Did you calculate what the financial position of the ESOP would have been if the transaction in question had not occurred?
A. It would have had very little money in the trust. Contributions I believe ranged from $1000 to $1500 a year. Per person that is.
Respondent does not allege that it was improper for the ESOP to own the real estate in question. The only impropriety alleged by respondent was the fact that the ESOP acquired the property from a disqualified person.
The revenue agent first informed petitioners of his conclusion that they had engaged in a prohibited transaction in February 1985. Had petitioners rescinded the transaction on that date, in accordance with respondent’s regulations, they would have had to purchase the real estate at its value on that date. The plan’s records show that the value of the real estate as of Apr. 30, 1984, was $7,794,640 and that the value of the annuity, which petitioners had originally exchanged for the real estate, was $5,910,696. Based on these values, if petitioners had undone the prohibited transaction, the regulations would have required petitioners to pay the difference of $1,883,944 to the plan. In addition, petitioners would still have been liable for first-tier excise taxes for 1981 through 1985 in the total amount of $1,620,478.75, plus interest.
The second-tier 100-percent tax can be avoided by a correction of the prohibited transaction after the majority’s opinion in this case is rendered. See sec. 4961. However, if petitioners are required to undo the transaction in accordance with sec. 53.4941(e)-l(c)(3), Foundation Excise Tax Regs., quoted supra note 2, they would be required to pay the ESOP the greater of the ESOP’s original purchase price for the property or its fair market value at the time of rescission. Unless petitioners’ financial position allows them to do this, rescission, within the provisions of the regulations, would be impossible.
Interestingly, respondent’s agent indicated that he would have permitted petitioners to “correct” the transaction in a manner that would have been detrimental to the plan’s beneficiaries.
THE COURT: If the land was much more valuable at this time than it was when the trust purchased it, what would your recommendation have been, or your requirement have been?
THE WITNESS: Seeing as the family orientation of the plans and the payment was a joint 100 percent survivor annuity, I would have proposed to tear up the annuity, transfer ownership back to the Zabolotnys.
MS. ROLEK: Nothing more, Your Honor.
FURTHER REDIRECT EXAMINATION BY MRS. PICKEN
Q. Can correction occur at this stage?
A. Yes, it can.
Q. What would happen to the second tier tax liability?
A. The second tier tax liability would be eliminated.
It is clear that when respondent began his examination, the value of the asset transferred to the ESOP was more than the value of the annuity for which it was purchased. See supra note 6. The disparity would probably be even greater today since the value of the annuity would decrease as petitioners get older. The fact that respondent was, and seemingly still is, willing to accept such an act as a correction, despite the obvious adverse effect on the plan beneficiaries, demonstrates a failure to focus on the primary objective of the statutory scheme which was to protect plan beneficiaries.
Employment Retirement Income Security Act of 1974, Pub. L. 93-406, sec. 3003(a), 88 Stat. 829, 998.