On January 9, 2020, the Tax Court issued a Memorandum Opinion in the case of Ed Thielking Inc. v. Commissioner (T.C. Memo. 2020-5). The issue presented in Ed Thielking Inc. v. Commissioner was whether a corporate Employee Stock Ownership Plan (ESOP) and an Employee Stock Ownership Trust were qualified under IRC § 401(a) and IRC § 501(a), respectively.

Background to Ed Thielking Inc. v. Commissioner

The petitioner is an S corporation, incorporated in March 2006. Effective as of the date of incorporation, the petitioner established an employee stock ownership plan (ESOP), which was executed by the petitioner’s president and sole shareholder, Ed. At the same time, the petitioner established an employee stock ownership trust (ESOT), and the Ed was named trustee.

Upon resolution of the petitioner’s board of directors, a dividend payable in capital stock was issued to the Ed, who elected to have the petitioner contribute the dividend to his ESOT account. The petitioner claimed a deduction for the ESOT contribution, which largely offset its income. The petitioner followed this course of action from 2007 through 2011 (the years at issue).

The petitioner reported on Form 5500 (Annual Return/Report of Employee Benefit Plan) having only one participant for plan year 2007 (Ed). Ed’s father, a CPA, prepared a written appraisal that valued each share of the petitioner’s stock at $1, resulting in a valuation of $23,000 for the shareholder’s ESOT account.

The appraisal, however, did not include the CPA’s signature or his qualifications as an appraiser. The same process repeated in 2008, but in 2009, Ed’s wife was reported on Form 5500 for the first time. Again, the CPA (Ed’s dad) valued the petitioner’s stock at $1/share, and he failed to sign the appraisal or include his qualifications. No Form 5500 was submitted for 2010 or 2011.

Declaratory Judgment Regarding Disqualification

IRC § 7476(a) authorizes the Tax Court to render a declaratory judgment relating to the qualification of a retirement plan, subject to the limitations in IRC § 7476(b). Such limitations did not come into play in the present case. After examining the S corporation’s returns, the IRS determined that the ESOP and the ESOT failed to qualify under IRC § 401(a) and IRC § 501(a), respectively, because the ESOP had both operational and form failures.

The IRS determined that the operational failures included: (1) allowing ineligible individuals to participate in the plan, (2) accepting contributions in excess of the limitations imposed by IRC § 401(a)(16) and IRC § 415(c)(1), and (3) failing to have an independent appraiser value employer securities as required by IRC § 401(a)(28)(C). Finally, the IRS determined that the plan failed to qualify in form because it did not conform to certain statutory and regulatory requirements, and the petitioner did not adopt timely amendments as permitted by IRC § 401(b).

The IRS’s determination to disqualify a stock bonus, pension, or profit-sharing plan is presumed correct, and the petitioner bears the burden of proving that respondent abused his discretion in doing so. See Tax Court Rule 142(a); Oakton Distribs. Inc. v. Commissioner, 73 T.C. 182, 188 (1979). To satisfy its burden of proof, the petitioner must persuade the Tax Court that the IRS’s determination was unreasonable, arbitrary, or capricious. See Buzzetta Constr. Corp. v. Commissioner, 92 T.C. 641, 648 (1989). In this case, the petitioner failed to do so.

Three Year Statute of Limitations of IRC § 6501(a) Not Applicable

The petitioner contends that the IRS erred in issuing its revocation letter because the statute of limitations had run with respect to one or more of the plan years at issue. However, IRC § 6501(a) limits only the assessment and collection of tax; it does not limit the IRS’s broad authority to audit retirement plans and, if appropriate, to issue a final “non-qualification letter.” As determinations about qualification of retirement plans do not involve the imposition of any tax, proceedings under IRC § 7476, and such determinations under IRC § 401(a) do not implicate IRC § 6501(a). Christy & Swan Profit Sharing Plan v. Commissioner, T.C. Memo. 2011-62, at *3.

Requirements for Plan and Trust to be “Qualified”

In order for an ESOP and its underlying ESOT to qualify for preferential tax treatment under IRC § 501(a), the ESOP must meet the IRC § 401(a) requirements in both form and operation. Ludden v. Commissioner, 620 F.2d 700, 702 (9th Cir. 1980), aff’g 68 T.C. 826 (1977); Treas. Reg. § 1.401-1(b)(3). Additionally, the terms of the stock bonus, pension, or profit-sharing plan must be in writing. See Employee Retirement Income Security Act of 1974 (ERISA), Pub. L. No. 93-406, § 402(a)(1), 88 Stat. at 875; see also Treas. Reg. § 1.401-1(a)(2).

Congress established the writing requirement so that every employee, on examining the retirement plan document, may 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). A qualification failure pursuant to IRC § 401(a) is a continuing failure, and, therefore, once the plan fails in one year, fails in all subsequent plan years until the failures are remedied. See Pulver Roofing Co. v. Commissioner, 70 T.C. 1001, 1015 (1978); Martin Fireproofing Profit Sharing Plan & Tr. v. Commissioner, 92 T.C. 1173, 1184 (1989).

Form Failures

A plan must be continually amended to comport with subsequent changes to the requirements under IRC § 401(a). Ronald R. Pawlak, P.C. v. Commissioner, T.C. Memo. 1995-7, *5. A form failure occurs when a plan document does not contain required language or terms. Family Chiropractic Sports Injury & Rehab Clinic, Inc. v. Commissioner, T.C. Memo. 2016-10, *12. A form failure may result from a statutory or regulatory change that renders the existing plan terms deficient. Treas. Reg. § 1.401(b)-1(b)(3)(i). The IRS, at its discretion, may designate a provision that fails to conform to a change in the law as disqualifying the entire plan. Id. However, a plan may retroactively qualify under IRC § 401(a) if remedial amendments are made during the remedial amendment period. IRC § 401(b); Treas. Reg. § 1.401(b)-1(d). In the present case, no amendments were made – remedial or otherwise – despite at least three major changes to the law during the years at issue. See Small Business Job Protection Act of 1996, Pub. L. No. 104-188, § 1452(a), (d)(1), 110 Stat. at 1816 (repealing IRC § 415(e)); Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Pub. L. No. 107-16, § 613(a), (d), 115 Stat. at 100, 101 (amending definitions under IRC §§ 416(i)(1), (g)); and Rev. Proc. 2002-29, § 3.01 (amending, e.g., IRC § 401(a)(9)(B)(i)).

Operational Failures – Generally

In determining a stock bonus, pension, or profit-sharing plan’s qualification under IRC § 401(a) the operation of the plan is as relevant as its terms. Winger’s Dep’t Store, Inc. v. Commissioner, 82 T.C. 869, 876 (1984); Treas. Reg. § 1.401-1(b)(3). An operational failure occurs when the operation of a stock bonus, pension, or profit-sharing plan fails to meet the requirements of IRC § 401(a) or comply with the terms of the plan document. See, e.g., Hollen v. Commissioner, T.C. Memo. 2011-2, *3-*4 (finding that a plan failed to qualify because it did not adhere to its own vesting schedule), aff’d per curiam, 437 F. App’x 525 (8th Cir. 2011).

Operational Failures – Ineligible Individuals Permitted to Participate in the Plan

Even though the ESOP stated that eligibility to participate began “immediately after one year of service” and only after the participant completed at least 1,000 hours of service within the year, the petitioner reported Ed in February 2007, less than a year after the plan was created, and likely even before Ed had completed 1,000 hours of service.

Operational Failures – Excess Contributions Under IRC §§ 401(a)(16) and 415(c)

Employee stock option plan contributions and other additions with respect to a participant are limited to the lesser of $40,000 (adjusted for inflation) or 100% of the participant’s compensation. IRC § 401(a)(16) (qualification limits); IRC § 415(c)(1) (contribution limitations); IRC § 415(d) (inflation). The petitioner failed to provide evidence of Ed’s compensation, salaries, or wages for 2007 as required by IRC § 415(c)(3).

For that matter, the petitioner failed to provide any evidence that Ed had performed any duties for the company. Consequently, Ed’s contribution limit for 2007 was zero. Because the petitioner contributed $23,000 (using the petitioner’s value) to the ESOT in 2007, it substantially exceeded the contribution limit under IRC § 401(a)(16) and IRC § 415(c).

Operational Failures – Failure to Satisfy the Independent Appraiser Requirement

The IRS determined that the petitioner’s ESOP failed to satisfy the independent appraiser requirement of IRC § 401(a)(28)(C). An “independent appraiser” means any appraiser meeting the requirements of a “qualified appraiser” under the regulations promulgated under IRC § 170(a)(1). IRC § 401(a)(28)(C). The Treasury Regulations provide a list of persons who cannot serve as a “qualified appraiser.” Treas. Reg. § 1.170A-13(c)(5)(i)(C).

The regulations exclude the donor of the property from the list of persons eligible to serve as “qualified appraisers.” Treas. Reg. § 1.170A-13(c)(5)(iv)(A). Further, any related party (within the meaning of IRC §§ 267(b), (c)) to the donor is also excluded. See IRC § 267(c); Treas. Reg. § 1.170A-13(c)(5)(iv)(E).

Ed is considered the “donor” of the property and is, therefore, an excluded person. Further, because Ed was also the sole beneficiary of the ESOT in 2007, he constructively owned all of the petitioner’s stock in 2007. IRC § 267(c)(1). Ed’s daddy, the “qualified appraiser” similarly is deemed to constructively owns all the stock that his son owns. IRC §§ 267(c)(2), (4). Ed’s father is, therefore, a related person, and not an independent or “qualified” appraiser.

Beyond the requirement that the appraiser not being a related person under IRC § 267, the Treasury Regulations impose further collateral requirements: the appraiser must declare that he holds himself out to the public as an appraiser, the appraiser must sign the appraisal, and the appraiser must list his or her background, experience, education, and membership, if any, in professional appraisal associations. Treas. Reg. §§ 1.170A-13(c)(5)(i)(A) and (B).

Although the petitioner’s appraisal contains a declaration, it is unsigned, and, therefore, fails to meet the first and second collateral requirements. See Hollen, T.C. Memo. 2011-2 at *4; see also K.H. Co., LLC Emp. Stock Ownership Plan v. Commissioner, T.C. Memo. 2014-31, *27-*32. The appraisal fails the third collateral requirement because CPA did not list his qualifications. See Churchill, Ltd. Emp. Stock Ownership Plan & Tr. v. Commissioner, T.C. Memo. 2012-300, *20-*23.

Substantial Compliance – Only Applicable When Requirement is Procedural or Directory

The petitioner contends that the substantial compliance doctrine applies to excuse both the independence and collateral requirement failures. However, the doctrine of substantial compliance generally applies only when the requirement is procedural or directory and does not relate to the essential requirements of the statute or regulation. Taylor v. Commissioner, 67 T.C. 1071, 1077-1078 (1977). The Tax Court concluded that the independence requirement of Treas. Reg. § 1.170A-13(c)(5)(iv) relates to the essence of IRC § 401(a)(28)(C); therefore, substantial compliance cannot excuse failure to strictly comply with the independence requirement. As such, the Tax Court found that the IRS had not abused its discretion in determining that the plan did not qualify under IRC § 401(a) in 2007, and because such a failure is continuing in nature and was not otherwise remedied, the plan was a failure for all subsequent years, as well. See, e.g., Martin Fireproofing Profit Sharing Plan & Tr., 92 T.C. at 1184.

The moral of the story, if there is one, is that skimping on an appraisal by using your dad or your idiot brother Chuck, who may or may not be qualified in the first place, is not worth the savings in the long run. Besides which, Chuck chewed paint as a kid like they were potato chips, and watermelon spitting champ four years running is not a “qualification,” at least as far as appraisers go…

(T.C. Memo. 2020-5) Ed Thielking, Inc. v. Commissioner

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