A series of problems led to the Tax Court agreeing with the IRS that an employee stock ownership plan (ESOP) and trust (ESOT) were not qualified in the case of Ed Thielking Inc. v. Commissioner, TC Memo 2020-5.[1]

The case involved an S corporation that was wholly owned by Ed Thielking. His father, a CPA, developed a plan for the S corporation to adopt an ESOP.[2] The plan was adopted on March 31, 2006 with an effective date of March 10, 2006.[3] The Court describes the following details of the plan’s terms and implementation:

Article 2 of the ESOP agreement states in pertinent part that participation in the ESOP begins immediately after one year of service, provided the participant is at least 21 years old on that date. In addition to the year of service, article 4 of the ESOP agreement states that employer contributions to the plan require at least 1,000 hours of service during a plan year. The ESOP agreement defines an hour of service as an hour for which an employee is paid or entitled to payment by the employer.

Further, article 4 of the ESOP agreement incorporates the limitations under section 415(e). With regards to distributions, article 14 of the ESOP agreement states in pertinent part:

If distribution has begun on or before the Required Beginning Date and if the Participant dies before his entire Accrued Benefit has been distributed to him the remaining portion of his Accrued Benefit which is not payable to a beneficiary designated by the Participant's will shall be distributed within five years after the Participant's death or over the life of the beneficiary or over a period certain not extending beyond the life expectancy of the beneficiary, commencing not later than the end of the calendar year following the calendar year in which the Participant would have attained the age 70 ½.

The record contains no restatements or amendments to either the ESOP or the ESOT agreements, despite respondent's repeated requests for those documents on January 28, 2010, October 26, 2011, and January 31, 2012.[4]

Mr. Thielking contributed his ½ interest in Gray Thielking Electric (GTE) to the S corporation, and the flow through income from that partnership made up the primary source of the S corporation’s income.[5] Contributions were made to the plan as described by the Court:

Petitioner’s primary source of income in FYE 2007 was an income allocation from GTE. Petitioner did not report any compensation of officers or salaries and wages as deductible expenses. Nothing in the record indicates that petitioner filed employment and unemployment tax returns, or that it issued and filed Forms W-2, Wage and Tax Statement, or Forms 1099-MISC, Miscellaneous Income, for FYE 2007.

In FYE 2007 petitioner’s board of directors resolved to issue a dividend payable in capital stock to the participants of the ESOP or at their election to their ESOT accounts. The only plan participant, Mr. Thielking, elected for petitioner to contribute the dividend to his ESOT account. Petitioner claimed a deduction with respect to the ESOT contribution, which largely offset the income allocation to it from GTE. With no material variance, petitioner followed this course of action for all the years at issue. Petitioner issued share certificates representing the following class B capital stock dividends to Mrs. Thielking, as trustee for the ESOT…[6]

The only other contribution occurred on or about November 6, 2007, when the ESOT received a purported rollover contribution of $15,634 from a section 401(k) account of Mrs. Thielking. Petitioner's board of directors authorized the purchase by the ESOT of an additional 15,635 class B shares with the funds contributed in the section 401(k) rollover.[7]

The Court also described key factors related to the plan’s reporting as follows:

Petitioner reported on Form 5500, Annual Return/Report of Employee Benefit Plan, for PYE February 28, 2007, only one participant, Mr. Thielking. Mr. Thielking's account consisted of 23,000 shares of petitioner's stock. Stephen Thielking prepared a written appraisal that valued each share of petitioner's stock at $1, resulting in a valuation of $23,000 for Mr. Thielking's ESOT account. The appraisal, however, did not include Stephen Thielking's signature or his qualifications as an appraiser.

Petitioner also reported Mr. Thielking as the only participant in the ESOP5 on Form 5500 for PYE February 28, 2008. The plan received a rollover contribution on behalf of Mrs. Thielking during PYE February 28, 2008, even though she was not reported as a plan participant for that period. The plan reported total assets of 59,434 shares of petitioner's stock. Again, Stephen Thielking valued each share at $1, resulting in a net plan asset value of $59,434, but he again failed to sign the appraisal or include his qualifications.

Petitioner finally reported a second participant for the first time, Mrs. Thielking, on its Form 5500 for PYE February 28, 2009. Once again petitioner relied on an unsigned appraisal prepared by Stephen Thielking, valuing the 66,234 shares of petitioner held by the ESOT at $1 each, or $66,234.[8]

Readers who work with qualified retirement plans may have noticed a number of issues, and those with a background in ESOPs may have found some others. These issues did not fail to attract the attention of the IRS or the court.

For a retirement plan to be treated as a qualified plan (and thus eligible for the various tax benefits available for such plans), it must comply with the numerous requirements found in IRC §401(a)—which has subsections that number from (1) to (37). Many of those subsections have additional long and detailed provisions. Suffice it to say there are a lot of ways to create plan qualification issues—and if the plan fails badly enough to be treated as no longer qualified, the results are rather nasty, not of the least of which is the loss of tax deferral on contributions and earnings in the plan.

The Tax Court describes the matters as follows:

Section 401(a) lists requirements that must be met for a plan and its underlying trust to qualify for preferential tax treatment under section 501(a). A plan must meet the section 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); sec. 1.401-1(b)(3), Income Tax Regs. In addition, the terms of the plan must be in writing. Employee Retirement Income Security Act of 1974, Pub. L. No. 93-406, sec. 402(a)(1), 88 Stat. at 875; see also sec. 1.401-1(a)(2), Income Tax Regs. Congress established the writing requirement so that every employee, on examining the 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); H.R. Conf. Rept. No. 93-1280, at 297 (1974), 1974-3 C.B. 415, 458.

A qualification failure pursuant to section 401(a) is a continuing failure because allowing a plan to requalify in subsequent years would allow a plan “to rise phoenix-like from the ashes of such disqualification and become qualified for that year.” Pulver Roofing Co. v. Commissioner, 70 T.C. 1001, 1015 (1978).[9]

As the Court notes, there are two key issues:

Form Issues: The plan document must contain all terms required under the law. A failure of the plan document to contain the necessary terms will potentially trigger disqualification. As well, since Congress changes the rules from time to time, plans must be regularly amended to take into account new rules; and
Operational issues: Even if the plan document is pristine and totally up to date, if the plan is not operated in accordance with the plan terms and the law, the plan also faces potential disqualification.

Statute of Limitations

The taxpayer believed that the IRS had made a fundamental error—many of the items being questioned about the plan’s documentation and operation had occurred more than three years prior to the IRS raising the issues. However, the Court notes, the statute only applies to assessment of tax against years, and the basic issue of qualification of a plan does not fall directly into that category:

Before we reach the merits of respondent’s determination to disqualify the plan, we must address petitioner’s contention that respondent “erred in issuing its revocation letter because the statute of limitations has run with respect to one or more of the plan years at issue.” Petitioner’s limitations contention is misplaced. Section 6501(a) limits only the assessment and collection of tax; it does not limit respondent’s broad authority to audit retirement plans and, if appropriate, to issue a final nonqualification letter. The period of limitations prescribed by section 6501(a), therefore, does not apply to proceedings under section 7476 or to respondent’s determinations regarding the qualification of retirement plans under section 401(a), as they do not involve the imposition of any tax. Christy & Swan Profit Sharing Plan v. Commissioner, T.C. Memo. 2011-62, 2011 WL 913190, at *3. Accordingly, respondent’s determination to disqualify the ESOP is not barred by any period of limitations set forth in section 6501.[10]

This is crucial because, as was noted earlier, once a plan is disqualified due to form and/or operational issues, it remains permanently disqualified.

In this case it means the IRS has the right to consider events that took place all the way back to the origination of the plan in determining if the plan remains (or ever was) a qualified plan.

Form Issues

As was noted earlier, a plan must have all terms required by §401(a) in order to be considered a qualified plan. When the law changes, the IRS or Congress will generally set a date by which plan documents must be updated and provide that, in the interim, the plan is to be operated as if it has the required terms. But once that deadline hits, the fact that a plan might have never in operation violated the revised rules under the law won’t help if the plan document still contains contrary provisions.

The taxpayer may feel that all is well because they have a determination letter received when the plan was adopted that indicates the terms comply with the law. But such a letter only deals with the law that existed as of the determination letter date. And, as the Court notes in this case, the taxpayer never actually produced the determination letter the taxpayer claimed to rely on.

Under section 6110(k)(3), determination letters may not be used or cited as precedent, and this Court has refused to consider determination letters proffered by taxpayers. See Derby v. Commissioner, T.C. Memo. 2008-45, 2008 WL 540271, at *20 (concluding that a taxpayer could not rely on a determination letter issued to another taxpayer); see also Reserve Mech. Corp. v. Commissioner, T.C. Memo. 2018-86, at *49 (refusing to consider 39 determination letters because they cannot be used as precedent under section 6110(k)(3)). Consistent with section 6110(k)(3) and our precedent, petitioner cannot rely on a determination letter issued to a different taxpayer. Moreover, petitioner has failed to actually identify the determination letter on which it attempts to rely; even if it had identified it, petitioner failed to provide any evidence that both plans were identical.[11]

More importantly, the plan never showed that it had adopted any of the amendments that were necessary following the plan’s initial adoption in 2006:

Petitioner contends that it amended the ESOP agreement as required. Petitioner stated that it failed to provide respondent with the amendments because respondent did not request them and later because the Government seized its accountant’s records. These contentions are unsupported by the record. First, the plan documents and all amendments were repeatedly requested on at least three occasions — January 28, 2010, October 26, 2011, and January 31, 2012. Second, O&T’s records were not seized until September 12, 2012, months after the third request for the amendments. Finally, a taxpayer has a responsibility under section 6001 to maintain adequate records. Petitioner’s reliance on its accountant to maintain records does not relieve it of its responsibility to maintain its own records.[12]

While the Court did not rely solely on this failure to update the plan to find the IRS was justified in revoking the plan’s qualified status, clearly being unable to show the plan had been updated since 2006 was not a factor working in the plan’s favor.

Operational Issues

While the plan documentation issues were troubling, there were a number of significant operational issues.

A key issue that’s seen too often is the owner ignoring the participation rules in the plan when it comes to his/her own coverage. In this case the Court had trouble finding that either Mr. or Mrs. Thielking had actually performed the 1,000 hours of service for one year prior to entering the plan.

The Court pointed out that, based on the terms of the plan, it would have been impossible for anyone to qualify to enter it in the first year, which Mr. Thielking did:

Eligibility to participate in the ESOP began “immediately after one year of service”. Eligibility for contributions also required the purported participant to complete at least 1,000 hours of service within the plan year. Petitioner was [*12] incorporated on March 10, 2006, and reported Mr. Thielking as a plan participant on its Form 5500 for PYE February, 28, 2007.

Petitioner had not been incorporated for one full year when it reported Mr. Thielking as a plan participant; therefore, it is impossible for Mr. Thielking to have attained a year of service as of February 28, 2007. Moreover, the record contains no credible evidence establishing that Mr. Thielking performed services for petitioner that met the 1,000 hours of service requirement. The ESOP agreement defines an hour of service as each hour for which an employee is paid for the performance of duties. Petitioner did not report as deductions either officer compensation or salaries and wages for FYE February 28, 2007, and failed to otherwise provide any evidence that it compensated Mr. Thielking for any duties performed for petitioner. Because Mr. Thielking failed both prongs of the test for eligibility, his admission as a plan participant in PYE February 28, 2007, created an operational failure.[13]

And, although Mrs. Thielking did not enter the plan until the following year via a rollover, the Court had similar issues with her:

…[T]he ESOT accepted a rollover contribution from Mrs. Thielking during PYE February 28, 2008, but petitioner did not report Mrs. Thielking as a participant until PYE February 28, 2009. Because Mrs. Thielking was not a participant when the ESOT accepted the rollover contribution, an operational failure occurred.[14]

The Court also did not accept the taxpayer’s explanation for the lack of salaries paid not being evidence that, in fact, there was not 1,000 hours of service performed and these individuals were not employees. The Court notes:

We are not persuaded by petitioner's perfunctory contention that both Mr. and Mrs. Thielking performed substantial services for petitioner and were compensated in the form of year-end bonuses only if circumstances permitted. In the absence of any credible evidence in the record of the services performed or any material yearend bonuses paid in PYE February 28, 2007, we conclude that neither individual performed the requisite 1,000 hours of service.[15]

The IRS also contended that the contributions made to the ESOP were in excess of the amounts allowed under IRC §401(a)(16) and allocations to participants’ accounts were in excess of the amounts allowed under IRC §415(c). The Tax Court agreed, noting:

Employee stock option plan contributions and other additions with respect to a participant are limited to the lesser of $40,000 (adjusted for inflation, see sec. 415(d)) or 100% of the participant's compensation. Secs. 401(a)(16), 415(c)(1). As mentioned above, petitioner did not claim as deductions either officer compensation or salaries and wages for FYE February 28, 2007. See sec. 415(c)(3). Additionally, it failed to provide any evidence that Mr. Thielking performed any duties for petitioner. Consequently, Mr. Thielking's contribution limit for PYE February 28, 2007, was zero.

Because petitioner contributed property with an alleged value of $23,000 to the ESOT for the account of Mr. Thielking, it exceeded the contribution limit under sections 401(a)(16) and 415(c). This excess contribution constitutes an operational failure for PYE February 28, 2007.[16]

As well, the IRS argued that the appraisal performed by Mr. Thielking’s father failed to satisfy the independent appraiser requirements imposed by IRC §401(a)(28)(C). IRC §401(a)(28)(C) reads:

(C) Use of independent appraiser.—

A plan meets the requirements of this subparagraph if all valuations of employer securities which are not readily tradable on an established securities market with respect to activities carried on by the plan are by an independent appraiser. For purposes of the preceding sentence, the term “independent appraiser” means any appraiser meeting requirements similar to the requirements of the regulations prescribed under section 170(a)(1).

The first problem was that the appraiser was Mr. Thielking’s father, and the use of a related party as the appraiser is barred by the regulations:

An “independent appraiser” means any appraiser meeting the requirements of a “qualified appraiser” under the section 170(a)(1) regulations. Sec. 401(a)(28)(C). The regulations provide a list of persons who cannot serve as a “qualified appraiser”. Sec. 1.170A-13(c)(5)(i)(C), Income Tax Regs. Specifically, the regulations exclude the donor of the property, any party to the transaction in which the donor acquired the property, and the donee of the property from the list of persons eligible to serve as “qualified appraisers”. Sec. 1.170A-13(c)(5)(iv)(A), (B), and (C), Income Tax Regs. Any person related to any of the above within the meaning of section 267(b) is also excluded as a qualified appraiser (the constructive ownership rules of section 267(c) apply to this determination). See sec. 267(c); sec. 1.170A-13(c)(5)(iv)(E), Income Tax Regs.

Under section 267(c), stock owned by a trust is considered owned proportionately by its beneficiaries. Sec. 267(c)(1). Stock owned by an individual is constructively owned by his family members, including ancestors and lineal descendants. Sec. 267(c)(2), (4). Finally, stock owned by a corporation is considered owned by any individual owning more than 50% of the stock of the corporation. Sec. 267(b)(2).

As a starting point, petitioner, the donor of the property, is an excluded person. Mr. Thielking, as the sole beneficiary of the ESOT (in PYE February 28, 2007), constructively owned all of petitioner’s stock. See sec. 267(c)(1). Stephen Thielking, as Mr. Thielking’s father, constructively owns all the stock of petitioner that his son owns. See sec. 267(c)(2), (4). Because Stephen Thielking constructively owns more than 50% of petitioner, he is a related person and is not an independent appraiser.[17]

In addition to being a related party, Mr. Thielking’s father also failed to sign the appraisal, another requirement imposed for a proper independent appraisal.

In addition to the independence requirement the regulations impose certain collateral requirements: (1) the appraisal must include a declaration that the individual holds himself out to the public as an appraiser and (2) the qualified appraiser who signs the appraisal must list his or her background, experience, education, and membership, if any, in professional appraisal associations. Sec. 1.170A-13(c)(5)(i)(A) and (B), Income Tax Regs. The appraisal letters covering PYE February 28, 2007, through PYE February 28, 2009, state that “[t]he undersigned holds himself out to be an appraiser.” However, because there is no signature below that statement or elsewhere on the letters, the appraisals fail the first collateral requirement. See Hollen v. Commissioner, 2011 WL 13637, at *4; see also K.H. Co., LLC Emp. Stock Ownership Plan v. Commissioner, T.C. Memo. 2014-31, at *27-*32. The appraisals fail the second collateral requirement because Stephen Thielking did not list his qualifications. See Churchill, Ltd. Emp. Stock Ownership Plan & Tr. v. Commissioner, T.C. Memo. 2012-300, at *20-*23.[18]

The taxpayer argued that the plan should be excused what it viewed as violations of these technicalities, arguing that the plan had achieved substantial compliance with the law. The Court did not agree, noting:

Petitioner relies on Bond v. Commissioner, 100 T.C. 32 (1993), where the Court found the regulations under section 170(a) are directory and not mandatory with respect to the section 170 statutory purpose. In Bond the Court did not, however, address the independence requirement of section 401(a)(28)(C). We conclude that the independence requirement of section 1.170A-13(c)(5)(iv), Income Tax Regs., which bars certain related people from serving as qualified appraisers, relates to the essence of section 401(a)(28)(C) — therefore the doctrine of substantial compliance cannot excuse the independence requirement.[19]

The taxpayer also argued that the Court had previously ruled that his father’s appraisals in another case met the substantial compliance requirement—but the Tax Court found that the facts of that case were different in important ways, noting:

…[P]etitioner contends that, in Val Lanes Recreation Ctr. Corp. v. Commissioner, at *23-*24, this Court previously found that Stephen Thielking was an independent appraiser. But see Churchill, Ltd. Emp. Stock Ownership Plan & Tr. v. Commissioner, at *24-*25 (finding that Stephen Thielking was not an independent appraiser because, inter alia, he failed to sign the appraisals and include his qualifications). Val Lanes, however, is distinguishable on multiple grounds. First, Stephen Thielking had no familial relationship with the primary beneficiary of the employee stock option plan in Val Lanes. Second, while the appraisals in the record did not include a signature, the Court there found on the basis of credible testimony — absent here — that signed appraisals were in fact provided to the Department of Labor. In contrast, here, Stephen Thielking valued stock beneficially owned by his son, and nothing in the record indicates that the appraisals were ever signed.[20]

Given the multiple problems found, it’s not surprising the opinion concludes:

Because of the operational and form failures set forth above, we find no abuse of discretion in respondent's determination that the plan does not qualify under section 401(a) for PYE February 28, 2007, and because it is a continuing failure, all subsequent plan years. See, e.g., Martin Fireproofing Profit Sharing Plan & Tr. v. Commissioner, 92 T.C. 1173, 1184 (1989). We sustain respondent's determination that the ESOP and the ESOT were disqualified for the 2007 plan year and for all plan years thereafter.[21]

[1] Ed Thielking Inc. v. Commissioner, TC Memo 2020-5, January 9, 2020, https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=12130 (retrieved January 10, 2020)

[2] His father had been involved in three prior cases before the Tax Court, including one from 2018 that was the subject of an article on the Current Federal Tax Developments site when it was issued. See Ed Zollars, “Use of CPA Who Did Significant Other Work for ESOP and Sponsor as Appraiser Did Not Run Afoul of Independent Appraiser Requirements,” Current Federal Tax Developments website, June 28, 2018, https://www.currentfederaltaxdevelopments.com/blog/2018/6/28/use-of-cpa-who-did-significant-other-work-for-esop-and-sponsor-as-appraiser-did-not-run-afoul-of-independent-appraiser-requirements

[3] Ed Thielking Inc. v. Commissioner, p. 3

[4] Ed Thielking Inc. v. Commissioner, p. 4

[5] Ed Thielking Inc. v. Commissioner, pp. 3-4

[6] Ed Thielking Inc. v. Commissioner, p. 5

[7] Ed Thielking Inc. v. Commissioner, p. 6

[8] Ed Thielking Inc. v. Commissioner, pp. 6-7

[9] Ed Thielking Inc. v. Commissioner, pp. 9-10

[10] Ed Thielking Inc. v. Commissioner, p. 9

[11] Ed Thielking Inc. v. Commissioner, pp. 22-23

[12] Ed Thielking Inc. v. Commissioner, pp. 23-24

[13] Ed Thielking Inc. v. Commissioner, pp. 11-12

[14] Ed Thielking Inc. v. Commissioner, p. 12

[15] Ed Thielking Inc. v. Commissioner, p. 13

[16] Ed Thielking Inc. v. Commissioner, pp. 13-14

[17] Ed Thielking Inc. v. Commissioner, pp. 15-16

[18] Ed Thielking Inc. v. Commissioner, pp. 16-17

[19] Ed Thielking Inc. v. Commissioner, p. 17

[20] Ed Thielking Inc. v. Commissioner, p. 18

[21] Ed Thielking Inc. v. Commissioner, p. 24