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IRS Has an Unlimited Time to Assess Excise Tax When Form 5330 Is Not Filed.

(Parker Tax Publishing September 16, 2015)

The Tax Court did not abuse its discretion by reconsidering a mistake it made and, thus, its holding that the IRS has an unlimited period of time to assess excise tax if Form 5330 is not filed, regardless of whether the taxpayer has notified the IRS in other filings of a prohibited allocation with respect to S corporation stock held by an ESOP, was affirmed. Law Office of John H. Eggertsen v. Comm'r, 2015 PTC 319 (6th Cir. 2015).


In 1998, John Eggertsen purchased all the outstanding shares of stock in a corporation which then elected to be taxed as an S corporation. Eggertsen had a law practice which he ran through the S corporation. In 1999, Eggertsen's law firm established an employee stock ownership plan (ESOP) and Eggertsen transferred the S corporation stock to the ESOP in order to obtain favorable tax treatment. All of the stock in the ESOP was allocated to John. As a result of the ESOP holding the S corporation stock, the law firm would not pay tax on its income but would pass it through to its owner, the ESOP; the ESOP would not owe tax at the plan level and Eggertsen, who ultimately owned the shares, would not owe tax on the income generated in the ESOP until the stock was distributed at retirement.

Many ESOPs, including Eggertsen's, did not have broad-based employee coverage and did not benefit the rank-and-file employees as well as they benefited highly compensated employees and historical owners. Congress found this to be a problem and, in 2001, amended the ESOP provisions to require broad-based employee ownership. Affected taxpayers were given a grace period to come into compliance with the new rules. A 50 percent excise tax on S corporation ESOPs that violated the new rule was imposed. The new rule came into effect on January 1, 2005, for the law firm's ESOP. The new legislation also provided that, if an ESOP did not meet the new requirements, the plan would face other stiff penalties, including loss of its ESOP status. This rule also came into effect on January 1, 2005, but the law firm's ESOP had an additional six months (until June 30, 2005) to comply with respect to the pre-2005 allocation made to Eggertsen.

Eggertsen filed Form 1120S for tax year 2005, and attached Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc. The company's return showed that the ESOP owned 100 percent of the stock of the company. The ESOP filed Form 5500, Annual Return/Report of Employee Benefit Plan for 2005. On the return, the ESOP showed (1) that it was maintained by the company; (2) that there were three participants, one of which was identified by name and two others who were not named but were listed as "active participants"; (3) the value of the assets held; and (4) that the assets consisted exclusively of employer securities. An amended Form 5500 was subsequently filed which showed the year end value of employer securities held by the ESOP as being $401,500. The ESOP did not file Form 5330, Return of Excise Taxes Related to Employee Benefit Plans, for 2005.

In 2011, the IRS issued a notice of deficiency determining that Eggertsen was a disqualified person with respect to the ownership of the S corporation stock in the ESOP and, as a result, a non-allocation year occurred with respect to the ESOP in 2005. Thus, Eggertsen owed an excise tax of 50 percent of the prohibited allocation of $401,500.

Tax Court Decision

Under Code Sec. 409(p)(3)(A), a nonallocation year is any plan year of an ESOP holding shares in an S corporation if, at any time during the plan year, disqualified persons own at least 50 percent of the number of outstanding shares of the S corporation (including deemed-owned ESOP shares) or at least 50 percent of the sum of the outstanding shares of the S corporation (including deemed-owned ESOP shares) and the shares of synthetic equity in the S corporation owned by disqualified persons. Under Code Sec. 409(p)(4), a person is disqualified if the person is either a member of a deemed 20-percent shareholder group, or a deemed 10-eprcent shareholder. The law firm and the IRS agreed that 2005 was a nonallocation year.

The Tax Court held that 2005 was a nonallocation year with respect to the ESOP, resulting in the imposition of the excise tax on any ownership by Eggertsen. However, the court concluded that the statute of limitations in the Code Sec. 4979A provision for assessing the excise tax had expired. Subsequently, in Eggertsen P.C. v. Comm'r, 143 T.C. No. 13 (2014), the Tax Court said it made a mistake on the statute of limitations issue and reversed itself, holding that the general statute of limitations under Code Sec. 6501, rather than under Code Sec. 4979A, applied for assessing an excise tax stemming from an impermissible allocation of securities in an ESOP. Thus, Eggertsen was liable for the excise tax.

Observation: The Tax Court's holding effectively gives the IRS an unlimited period to assess excise tax if Form 5330 is not filed, regardless of whether the taxpayer has notified the IRS of the prohibited allocation in other filings.

The law firm appealed. On appeal, the law firm raised three alternative arguments: (1) it did not owe any excise tax for 2005; (2) the three-year statute of limitations in Code Sec. 6501 bars the assessment; and (3) the Tax Court should not have entertained the IRS's motion for reconsideration.

Sixth Circuit Analysis

The Sixth Circuit rejected the law firm's arguments and affirmed the Tax Court's holding. The court noted that both the law firm and the IRS agreed that 2005 was a nonallocation year. The Sixth Circuit agreed with that determination as well. That left the question, the court said, of whether such reality triggered the excise tax. Citing the language in Code Sec. 409(p)(3), the Sixth Circuit said it did.

With respect to the statute of limitations issue, the court noted that there are several exceptions to Code Sec. 6501's general rule that the IRS has three years to assess a tax after a return is filed.

First, the court observed, the limitations clock may start in some settings even when the taxpayer fails to file the right return or filed the wrong return but with all of the necessary information. A key predicate for this exception is that the return filed must contain sufficient data to calculate tax liability. In this instance, however, the filed returns would not allow the IRS to calculate the law firm's excise tax liability.

Second, the court noted, the statute of limitations sometimes starts based on a more generous notice standard, which looks not to whether "the return" has been filed but whether a filed form provides a clue as to an omission. But this notice standard, the court said, concerns only Code Sec. 6501(e), a provision not applicable in this case. According to the court, the question was not whether the law firm made an omission on a filed return; it was whether it filed the right return at all.

Third, Code Sec. 6501(b)(4) provides that, for the excise tax in Code Sec. 4979A and other excise taxes, the limitations clock may begin with the filing of a return on which an entry has been made with respect to the applicable excise tax. The court noted that while the law firm may have made entries on its other returns with respect to the Code Sec. 4979A tax, the law firm made no entry that would alert the IRS to the occurrence of a nonallocation year. Thus, that exception did not apply.

Finally, the Sixth Circuit said that the Tax Court did not abuse its discretion by using reconsideration to correct a mistake. The Sixth Circuit said it knew of no case where a lower court, acting within the bounds of the applicable procedural rules, granted reconsideration to correct an acknowledged mistake and a federal court held on appeal that doing so was incorrect.

For a discussion of ESOPs and S corporations, see Parker Tax ¶33,560. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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