Michael C. Hollen, D.D.S., P.C., Petitioner

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

SERED JAN - 4 2011

qualif ed under sections 401(a) and 501(a) , respectively.¹ Respondent determined that the ESOP and the ESOT did not qualify under ections 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 fór decision under Rule 122.

We granted their motion and decide this case on the basi of the pleadings and the stipulated administrative record.

See Rule 217 (a) .

We incorporate the stipulåted record herein.

Petitioner is a professional corporation that reports its income and expenses on the basis of the calendar year.

It employs its principal sharehólder, 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.

Pet-itioner began sponsoring the.ESOP on November 1; 1986.2 The ESOP's administrator is Úr: Hollen; he also is the ESOT's trustee.

The ESOP's plan year initially ended on October 31 but U less otherwise noted, section references are to the the Iriternal Revenue Code, and Rule applicable versions of referen es are to the Tax Court Rules of Practice and Procedure.

2T¹ e earliest plan document in the record is from Sept. 15, 'he record is unclear whether the plan applied for or 1994. receiÝe a favorable determination letter from the Internal ReÝenuel Service at inception.

lì 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 no'nqualification letter, which underlies this proceeding.

Discussion S ction g476 (a) authorizes this Court to render the requested declaratory judgment, subject to the limitations of sectio i 7476 (b) ., Neither party arguese that any -of those limita ions is not met, and we are satisfied that we have jurisd ction over the petition.

See generally Efco Tool Co. v.

Commis ioner, 81- T.C. 976 ( 983) (discussing this. Court's a jurisd ction in the setting of a declaratory judgment case such R spondent determined,that the ESOP and the ESOT failed to qualif unders sections 401(a) and 501(a) , respectively, because:

(1) Thé ESOP was not timely amended to include provisions a required by sections 402 (c) ( ) (C) , 414 (n) (2) (C) , (q)-,- and i (u)3 and 415 (c) (3) ; (2) the ESOP failed to follow the vesting schedule requir d by section 411(a) (2) (B) ; (3) the ESOP failed to use' an iudepe dent appra:Lser tO appraise ' emplOyer Secui~itieS Jas required by sect ion 401(a) (28) (C) ; and (4) the beneficiary account of Dr.

Hollen exceededa the allowable amount of annual additions for the 198 9 p]ìan ye ar .

Respondent'-s determinat .on is presumed to be correct, and the bunden of proof is on petitioner.³ - See Rule 142 (a) ; Welch v.

"I certain cases, sec. 7491(a) places the burden of proof to any factual 'is'sue relevant on the |Commissidrier "with respect to ascèrtaining the liability of income or estate] tax" .

the taxpayer for any [Federal We need not decide whether sec . 7491 (a) (continued. .

. ) Helvering, 290 U.S. 111, 115 (1933).

To prevail, petitioner must prove that respondent abused his discretion. Under this a 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 do 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)

See also sec.

1.401-1(a) (2), Income Tax"Regse Congress established the writing requirement-so that every employee may, -on examining the plan document, determine exactly whát his or her rights and obligations are under the plan and who is resýonsible for operating the plan.

See Curtiss-Wbight Corpi v. Schooneiongen, 514 U.S. 73,. 83 (1995); H.; Conf. Rept. 93-1280,- at 297 (£974), 3(...continued) applies to declaratory judgment actions such as this. This is because sec. 7491(a) is not applidable where, as here, taxpayer makes no argument as to the -applicability of and fails to show that have been met.

the prerequisites for its applicability the the section 1974-3 C.B. 415, 458. With these basic principles in mind, we turn t analyzing respondent s determination as- to the-ESOP's qualif cation under section 401(a) .

We do notsspecifidally discus 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. Coåmissioner,- supra Disqualifying Reason 1:

ESOP Not Properly Amended T¹ Small Business Job Protection Act of 1996, Pub.

104-188, .110 Stat. 1755, and the Internal Revenue Serviõe Restructuring andyReform.Act of 1998, Pub. L. 105-206, 112/Stat.

685, amended the plan qualification requirements under sections 402 (c) ( ) (C) (eligible rolloter distributions) , 414 (n) (2) (C) (def inition of employee leasing) , 414 (q) (def inition of "highly compensated employee) , 414 (u (special rules for veterans) , nd 415 (c) ( ) (D) (participants' dompensation) . Respondent -determined that th ESOP did not qualif under section 401(a) becauselit was not tim ly amended to reflecti these flaws.

Pe itioner did not amend the ESOP in accordance with the effecti e dates set forth in the referenced statutes.

* All tlie same, the ESOP may retroactively qualify under section 401(a) if remedial amendments were made during the remedial amendment period desc ibed in section J .401(b) -1,"Income 'i'ax Regs.

That section provides that a.plan such as the ESOP may qualify retroactively if:

* * with respect the remedial. amendment on or before the last day of period * provision, all provisions of 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 Income Tax Regs.] [Sec. 1.401(b)-1(a), period.

to such disqualifying the plan which are * * * 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.

Section Required Effective Date Amendment Adopted Date .

Amendment Effective Date 402(c) (4) (C) 414(n) (2) (C) 414(q) 414(u) 415(c) (3) (D) Jan. 1, 1999 Nov. 1, 1997 Nov. 1, 1997 Dec. 12, 1994 Dec. 31, 1997 Jan. 1, 2001 Jan. 1, 2001 Jan. 1, 2001 Jan. 1, 2001 Jan. 1, 2001 Jan. 1, 2001 Jan. 1, 2001 Jan. 1, 2001 Jan. 1, 2001 Jan. 1, 2001 4The remedial amendment period extension provision of sec.

1.401(b)-1(e) (3), petitioner requested the determination letter on Dec. 27, 2002, after the remedial amendment period expired.

Income Tax Regs., does not apply because A]though the ESOP adopt d its amendments on January l', 2001, before the expiration of the remedial amendment period, the amendment failed'to make the provisions effective is of the required effective dates.

The ESOP'is therefore not qualified under section 401(a) because the required provisions faileil to be effective for the whole of t e remèdial amendment period.

See - sec. 1.401(b) -1, Income Tax eg ; see also Ronald R.

'Èawlak P.C. v. Commissioner, supra.

Disqualifying Reason 2: Certain Plan Participants Not Credited According to Vesting Schedule Se tion 401(a) (7) requi es that the ESOP satisfy the vesting require ents of section 411. Section 411(a) (2) (B) (iii) provides for a y sting 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 I follow that schedule .

The following chart shows t e vesting percentage reflected in the ESOP' s records compare with those required under section 411(a) (2) .5 Employee Vesting Percéntage Per Plan Re ords Vesting Percentage Required Under Sec . 411 (a) (2) Ann Tarr Susan Bess Jodi Robinson Cynthia Dunn Kerry Newland Sarahaheeter SP titioner claims that fany required corrections have bee made",, but the record does nåt substantiate this claim.

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 stock As relevant here, an "ihdependent appraiser" means a "qualified appraiser" as def ned by section 1.170A- 3 (c) (5) (I) Income Tax Regs.

Tl e ESOP fails at least two requirements of that* section Fi'rst, section 1.170A-13 (c) (N) (i) ; Income Nx U.egs., requ~ires that Él e appraisal summary c ntain a^ declaration that the individual holds himself out to the gublic as añ appreiser.

Thé apýrai al letters covering the 2001 t hrough 2003 plan years state that " he undersigned holds flimself - out to be an appraiser" Howe*èr, there is no signatuŸe below that statement on3riy of the letters (there is an unsigned line for "a signature with Åhe"word "appra ser" typed below) .

Second, section 1.170A-13 (c) (3) (ii) (F) and (5) (i) (B), Income Tax Regs., requikes that the qualifi d ap'prai er who signs the appraisal must lisé this or her background, experiénce, education, and membership, "if any, in professional appraisal associations.

The appraisal here is not signed, and the appraisal summary does not list the refe enced information.

We conclude that the ESOT'-s holdings of petitioner' s st ock were not valued by a "qualified appraiser" and that the ESOP therefc e fails the requirements of section 401(a) (28) (C) (and hence section 401(a) ) . Petitioner does not, assert that the substartial compliance doctrïne applies.

See Bond v.

Commissioner, 100 T.Cl 32 (1993) .

Disqualifying Reason 4: Hollen Excess Annual Additions Allocated to Dr.

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 employée 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 employer or certain allocat ions to participants'4 accounts as giving rise to annual additidns . " Respondent treated $150 , 33 9 of the $200,000 dividend as suc¹ an annual addition tè Dr. Hollen's account.

We review that determination for abuse of discretion, and we find ncne. Dr. Hollen was.the primary beneficiary of the $200,000 dividend distributed to the ESOT and of the ESOT's use of tho(e proceeds to repay a like amount of the borrowings obtained to purchase the stoak of petitioner.

That repayment was of fun s 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 prcximate to the distribution, was to provide petitioner with a deduction for the principa payments on the loans, see sec.

i 404 (a) (9) (A) , without any coi-responding 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 f cts, 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. 199 -266, affd. without published opinion 89 F.3d 841 (8th Cir 1996) .

We conclude that the ESÒP failed the requirement of section 401(a) ( 6) for the 1989 plan year because Dr. Hollen's ESOT 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 ve 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.³ 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, Decis-ion will be entered for respondent.

'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.

88. Stat. 875; requires that the plan be in writing.