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April 1994

Beware of prohibited transactions with ESOPs: a case in point. (employee stock ownership plans)

by Coker, Dianna Ross

    Abstract- Taxpayers seeking to minimize their tax burdens with the help of employee stock ownership plans (ESOPs) may actually incur more tax obligations if they enter into a prohibited transaction with the ESOP. Certain transactions with ESOPs are not allowed and are subject to a two-tier excise tax to protect the interests of plan beneficiaries. In some instances, excise taxes may still be levied even if a prohibited transaction is deemed favorable to the ESOP and its beneficiaries. This was the case with North Dakota farmers Anton and Bernel Zabolotny who transferred their oil well to an ESOP to avoid income, estate and gift taxes. However, they entered into an unauthorized property-annuity exchange transaction for which they were assessed considerable excise taxes by the IRS, a decision upheld by the tax court. Fortunately, the appellate court disagreed and allowed only a small portion of the taxes to stand.

Taxpayers incorporated their business and established an ESOP to avoid income, estate, and gift taxes. Unfortunately, they entered into a prohibited transaction with the ESOP and were assessed substantial excise taxes by the IRS. Showing no mercy, the tax court agreed. Fortunately for the taxpayers, the decision was reversed on appeal, and only a small portion of the taxes were let stand.

Employee stock ownership plans (ESOPs) have become popular qualified employee benefit plans for closely held corporations. To protect the interests of plan beneficiaries, some transactions are prohibited and subject to a two-tier excise tax.

A 1991 tax court decision involving farm property with mineral rights leased to Gulf Oil indicates excise taxes may be imposed on an individual taxpayer even if a prohibited transaction was favorable to the ESOP and its beneficiaries |Anton Zabolotny, 97 T.C. 385 (1991). Twelve judges signed the majority opinion, while seven judges dissented.

On review, the Eighth Circuit held the highly successful prohibited transaction was self-correcting and upheld only a small portion of the excise taxes imposed (93-2 USTC Para. 50,567).

Prohibited transactions with ESOPs include any direct or indirect sale, exchange, lending of money or extension of credit, or various other transactions between a qualified plan and a "disqualified person" (a person with any of certain relationships to the plan). A mandatory first-tier five percent excise tax, owed by the disqualified person, is imposed upon the amount involved in the prohibited transaction. Failure to correct the prohibited transaction within the first taxable year in which it takes place results in imposition of an additional five percent tax for each subsequent taxable year until there is a correction. If a correction is not made prior to the notice of deficiency, a second-tier tax is imposed: 100% of the transaction amount.

Facts in Anton Zabolotny

Husband and wife Anton and Bernel Zabolotny operated a North Dakota farm. In 1977, mineral rights were leased to Gulf Oil, with oil production royalty rights subsequently producing revenue in excess of $1 million annually.

On May 20, 1981, taxpayers and their son incorporated their farming operations under the name Zabolotny Farms, Inc. (Farms, Inc.). On the same date, the corporation adopted an ESOP, with Anton and Bernel Zabolotny as plan beneficiaries and Anton Zabolotny serving as trustee, having discretionary authority to manage the ESOP plan. Also on that date, the ESOP purchased from taxpayers their three tracts of farm land located in two counties, together with the mineral rights in the land. These tracts comprised the acres that taxpayers had been operating as a farm. In exchange, taxpayers received an unsecured joint and survivor private annuity contract established by the ESOP, entitling them to receive from the trust payments of $478,615 per year. The approximate present value of future payments under the joint and survivor private annuity plan equalled $6,481,915, which was therefore the amount of the exchange transaction. Relying on the advice of two practicing CPAs that the exchange was not a table transaction, taxpayers did not attempt to secure a special exemption from excise tax for sale of property to an ESOP.

On July 21, 1981, a determination letter for the ESOP was requested of the IRS District Director, and on February 1, 1982, a favorable letter was issued declaring the ESOP in question to be a qualified trust. On May 20, 1983, Anton Zabolotny, as ESOP trustee, entered into a five-year contract to lease the property's surface rights to Farm, Inc.; the ESOP retained mineral rights. Farm, Inc. operated both cattle and grain operations on the acreage.

On November 21, 1986, the IRS assessed Anton and Bernel Zabolotny excise tax deficiencies exceeding $17 million for the six-year period from 1981 to 1986. Assessed for each taxpayer, for each year, were a first-tier excise tax deficiency of $324,095.75 for 1981 through 1986, a second- tier assessment of $6,481,915 for 1986, and additions to tax for failure to file of $81,023.94 for 1981 through 1985. The excise tax was assessed on the 1981 property-annuity exchange transaction, which was characterized under IRC Sec. 4975(c)(1) as a prohibited transaction with disqualified individuals, i.e., the taxpayers.

Majority Opinion

The tax court was asked to decide if the sale of real estate to the ESOP was a prohibited transaction leading to excise tax as assessed by the IRS in its notice of deficiency. Statutory guidance is provided by ERISA and IRC Secs. 4975 and 6651.

In its decision, the majority opinion discussed five basic issues:

* Were taxpayers disqualified persons under IRC Sec. 4975(e)(2)?

* Was the property-annuity exchange a prohibited transaction between a disqualified person and a plan under IRC Sec. 4975(c)(1)?

* If the transaction had been prohibited, was it exempt from excise tax as provided under ERISA Secs. 406, 407, 408 and IRC Sec. 4975(d)(13)?

* If prohibited, was it simultaneously corrected as described in IRC Sec. 4975(f)(5)?

* Was an addition to tax under IRC Sec. 6651 applicable for failure to file excise tax returns?

Disqualified Persons. Taxpayers were found to be disqualified persons as a result of Anton Zabolotny being a fiduciary, both Anton and Bernel Zabolotny being officers of Farms, Inc. and 50% shareholders of Farms, Inc. (whose employees initially participated in the plan). Bernel Zabolotny was also a disqualified person as a family member of a fiduciary.

Prohibited Transactions. Both parties stipulated the ESOP was a trust qualifying to be a plan ruled by the prohibited transactions provisions. Because taxpayers were disqualified persons, their property-annuity exchange with the plan was found to be a prohibited transaction.

Exemption from Excise Tax. The third issue addressed whether the prohibited transaction was exempt from excise tax assessment on the basis of the land being "qualified employer real property" as provided by ERISA Sec. 407(d)(4). Specifically, petitioners argued that the transactions qualified for exemption under IRC Sec. 4975(d)(13), which provides the prohibited transactions restrictions of IRC Sec. 4975(c) shall not apply to any transaction exempt from ERISA Sec. 406 by reason of ERISA Sec. 408(e), which exempts acquisition, sale, or lease by a plan of qualifying employer real property as defined in ERISA Sec. 407(d)(4). Employer real property is real property leased to an employer of employees covered under the plan.

To be qualified, such a sale must be for adequate consideration, and no commissions must be charged for arranging such transactions. These two requirements were met in this case, but a dispute remained concerning ERISA Sec. 407(d)(4)(A) and (B), which requires employer real property be geographically dispersed and multipurpose (each parcel of real property and the improvements on it must be suitable, or adaptable without undue expense, for more than one use).

Before deciding on the issues of geographical dispersion, the parties discussed the portion of the transaction amount that might be exempt. On the date of sale, the real estate value was allocated $361,500 to farmland use and $6,120,415 to mineral rights. Taxpayers argued that the exempted amount should be the entire transaction amount, covering the surface and mineral rights. The IRS argued that only the fraction of the property's market value attributable to the surface rights could be considered employer real property. Taxpayers relied on ERISA Sec. 408(e) which provides that the property will qualify "even if such property is leased to one lessee," arguing this language implies real property does not have to be leased solely to an employer of employees covered by the plan in order to qualify. According to the tax court, however, the plain language of the statute indicates that since only the surface rights were leased to Farms, Inc., only the surface rights can be qualified employer real property. Thus, the mineral rights do not qualify as employer real property. Interestingly, the IRS did not suggest it was improper for the ESOP to own the real estate in question.

As for the surface rights leased back to Farms, Inc., taxpayer argued geographic dispersion is met because the property was dispersed vertically by including surface and subsurface fights. According to taxpayer, the term geographic differs from the term topographic because geographic refers to a cross-section of the earth, whereas topographic refers merely to surface configurations. Taxpayer argued the IRS was narrowing the definition of the term geographic to include only the surface rights of the property purchased by the ESOP.

The majority opinion of the tax court asserts Congress intended that term required "a number of parcels located in different geographical areas." The primary rationale for the geographic-dispersion requirement is to protect the ESOP plan from economic conditions peculiar to one area. In Anton Zabolotny, the real estate was located in identical geographic environments.

Taxpayers also argued multiple use of the property leads to geographic dispersion (e.g., surface rights used for farming and subsurface rights used for oil extraction). The tax court did not accept this position because it "confuses geographic dispersion with multiple use, which is a separate requirement for real property to be deemed qualified employer real property." Since taxpayer did not satisfy the geographic-dispersion requirement, the court did not take a position on the multiple-use requirement. The Court found the prohibited transaction did not involve qualified employer real property and therefore was not exempt from excise tax on that basis.

Correction. IRC Sec. 4975(b) provides for imposition of a tax equal to 100% of the transaction amount involved if the prohibited transaction is not corrected. Although Congress did not specify what is required for a correction. IRC Sec. 4875(f)(5) defines the terms "correction" and "correct" as 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.

Taxpayers asserted a correction occurred simultaneously on the purchase date. They argued that since their ESOP plan made a "substantial profit" on the original exchange transaction, the highest fiduciary standards were satisfied and the transaction was immediately corrected, thus ending the taxable period on the date of the prohibited transaction.

The majority of the tax court did not accept this position, although aware that by so doing the result was harsh due to the size of the amounts involved. A transaction is not deemed corrected simply because it turns out to be a good deal. The IRC and regulations "clearly look to some affirmative act to effect a correction, rather than to the financial success of the prohibited transaction." No evidence was presented showing that some appropriate affirmative act, such as a sale of the property by the ESOP to a third party, was not feasible. Thus, in the majority opinion, taxpayers had yet to correct the transaction. "To hold otherwise would effectively subvert the strict statutory guidelines presented by the prohibited transaction provisions." Given correction was not deemed to have taken place, the prohibited transaction could not be considered exempt from the second-tier 100% excise tax. And because the 100% tax is imposed on all disqualified persons participating in the prohibited transaction, the taxpayers each owed an amount equal to the original prohibited transaction amount.

Addition to Tax. The fifth issue concerned whether the addition to tax for failure to file excise tax returns could be avoided on the basis of taxpayers' claim that the failure to file was due to reasonable cause and not to willful neglect, as allowed in IRC Sec. 6651(a). Although reliance on an accountant to file is ordinarily no excuse for failure to file, it may be reasonable for a taxpayer to rely on substantive tax advice of an accountant that no return is needed. To be considered reasonable cause, it must be shown the taxpayer supplied all relevant information to a competent tax advisor and relied in good faith on the incorrect advice that no return was needed. In Zabolotny, taxpayers were found to have demonstrated reasonable cause sufficient to excuse their failure to file excise tax returns. The additions to tax were found to be not applicable.

Minority Opinion

Correction Was Made. In a minority opinion, Judge Ruwe disagreed with the majority that the prohibited transaction had not been "corrected." Taxpayers themselves were the beneficiaries of the ESOP; their interests as beneficiaries were protected. During the time they were beneficiaries, the plan's net asset value had increased by over $2 million as a result of the prohibited transaction. Not only were the beneficiaries' interests safeguarded, they were substantially enhanced as a result of the transaction. The minority report states that nothing salutary could be accomplished by undoing the transaction under these favorable circumstances, and that requiring such a recision would not be rational. To require the taxpayers to repurchase the property from the ESOP plan at its current value no matter how much it increased in value would have resulted in a financial disaster. In addition, the minority opinion disagreed with the majority that an affirmative act was indeed required and agreed with the taxpayers that 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. Judge Ruwe pointed to case law, government regulations, and Congressional intent to support his position.

The minority opinion asserted the statutory language of undoing the prohibited transaction to the extent "possible" should be interpreted as "practicable" or "reasonable." "Surely, Congress did not intend to require undoing a transaction without regard to the moral, ethical, legal, and rational consequences." Judge Ruwe also cited a claims court decision that had taken the position a correction within the private foundation area does not require the recision of a self-dealing transaction. In that case, the self-dealing transaction was not favorable because the foundation received less than fair market value for the stock it had sold in the prohibited transaction. The claims court held in that case a correction occurred when the foundation was subsequently paid the difference. The tax court minority opinion in Zabolotny asserted the claims court would have found the prohibited transaction had been immediately corrected if the foundation had received full value initially.

Judge Ruwe also pointed out that the regulations under IRC Sec. 4975 specifically recognize a situation where a correction can be accomplished without an affirmative act by the disqualified person. If a plan sells the property to a third party at a price greater than either current market on the date of the prohibited transaction or the amount paid the disqualified person, a correction is considered to have occurred.

The exemption procedure provided by IRC Sec. 4975(c)(2) was also seen as reflecting the intent of Congress to achieve common sense results so long as the plan and its beneficiaries are protected. That section provides that the Secretary of Treasury, after consultation and coordination with the Secretary of Labor, may grant a conditional or unconditional exemption of any disqualified person or transaction from the prohibited transaction excise tax if three conditions are met. The exemption must be a) administratively feasible, b) in the interests of the plan and of its beneficiaries, and c) protective of the rights of participants and beneficiaries of the plan. Judge Ruwe concluded the more rational approach for the IRS would have been to initiate this special exemption, thereby avoiding this litigation.

In summary, Judge Ruwe's minority opinion in the current case would have found the initial prohibited transaction was subject to the first-tier five-percent excise tax, that a "correction" of that transaction was evident by the end of the first taxable year, and therefore only the first-tier excise tax was applicable for 1981 only.

The ESOP Trust Was Not a Qualified Trust Due to the confiscatory aspect of the majority opinion, Judge Beghe in another minority opinion offered a third alternative. Judge Beghe suggested the ESOP trust was not a qualified ESOP trust, for several reasons. If that were the case, the IRS could retroactively revoke the qualified status of the trust. At least one decision holds that a purported pension trust that had received IRS approval of its qualified status did not qualify as an exempt trust from its inception.

Five conditions must be met for a determination to be immune from retroactive revocation: a lack of misstatement or omission of material facts, a lack of material difference between facts subsequently developed and the facts as submitted, stability, in the applicable law, the proposed or prospective nature of the transaction, and good faith reliance by the taxpayer on a ruling for which a retroactive revocation would be to his detriment. Judge Beghe pointed out several of these conditions were not satisfied in the current case. The determination request did not disclose the farmland and mineral interests had been transferred to the trust, resulting in omission of a material fact. The determination was not for a proposed transaction but one already accomplished; the trust formation and property transfer took place prior to the determination request. Therefore, taxpayers could not have relied on the determination. Judge Beghe concluded the IRS was free to revoke the determination the trust was a qualified trust.

Judge Beghe's minority opinion indicated the ESOP trust was not a qualified trust on the grounds it was not "designed to invest primarily in qualifying employer securities." The relevant regulations state that an ESOP may invest part of its assets in other than qualifying employer securities. The phrase "primarily" has not been interpreted by the IRS or the courts. The Department of Labor states the statute does not establish a fixed quantitative standard for the "primarily invested" requirement. Judge Beghe asserted the phrase implies the trust must hold the major portion of its assets in employer securities. The opinion indicates a majority of the trust assets in employer securities would be necessary, as well as sufficient, to satisfy the "invested primarily" requirement.

During the five years ending April 30, 1986, Farms, Inc. contributed only $12,900 to the ESOP, while the ESOP's gross royalty income of more than $9 million provided the wherewithal for the trust to buy shares of Farms, Inc. The royalties resulted from property contributed by taxpayers, not by Farms, Inc. Judge Beghe asserted taxpayer motives were not in line with Congressional intent to provide, by the use of corporate tax deductions for contributions to ESOPs, to facilitate the transfer of corporate stock to employees. His opinion maintained taxpayers appeared to have been primarily seeking their own income, gift, and estate tax objectives, "...to avoid current recognition of gain to themselves on the transfer of assets to the trust; to avoid any income tax on the trust income in excess of the current distributions being used to pay the joint and survivor annuity; by transferring the assets to an exempt trust instead of the corporation, to avoid corporation income taxes on the mineral royalty income...; and to use the facade of an ESOP to pass the remainder interests in the mineral royalties and farmland to the children free of gift and estate taxes." (The Zabolotny children, as employees of the corporation, became the primary ESOP beneficiaries, shortly after taxpayers terminated their employment and forfeited their entire interest in the ESOP on April 30, 1983.)

The minority opinion concluded that since the majority of ESOP trust assets were not primarily securities, the trust was not a qualified ESOP trust. Therefore, the imposition of excise taxes was inappropriate.

Reversal By the Eighth Circuit

On appeal, the Eighth Circuit essentially agreed with the tax court's minority opinion. The appeals court let stand the five percent excise tax for the year of the sale, but reversed with respect to the continued imposition of the first-tier tax as well as to the second-tier tax. According to the higher court, the five percent and 100% taxes do not apply if the transaction is corrected.

But there was no affirmative action by the disqualified person. No matter said the Eighth Circuit. The law "imposes no literal requirement that a disqualified person must take affirmative action before a transaction may be considered corrected." According to the plain reading of the tax law, the extent to which a disqualifying person must undo a prohibited transaction depends upon whether undoing it is possible and what effect the undoing would have on the financial position of the ESOP plan. The court emphasized the phrase in the IRC Sec. 4975(f)(5) "undoing the transaction to the extent possible." The only bright-line requirement is that after the correction, the plan must be "in a financial position not worse that in which it would be if the disqualified person were acting under the highest fiduciary standards."

Since transferring the land and minerals back to the Zabalotnys would be financially devastating to the ESOP, the court reasoned that the correction occurred by the end of the first taxable year. This court provided three basic reasons for the correction.

First, the Zabolotnys are both the disqualifying person who entered into this prohibited transaction as well as the ESOP's sole beneficiaries the prohibition against such transactions was intended to protect. The IRS has become engaged in a somewhat superfluous endeavor, trying to protect the Zabolotnys in their role as the sole plan beneficiary from themselves in their role as disqualified persons engaged in dealing with the plan. Second, the prohibited transaction has proved highly productive for the ESOP from the beginning, leaving it with assets of far greater value than what it would have accumulated from employer contributions alone. The nature of the corporation's enterprise, a farming operation in western North Dakota, made it unlikely that the corporation, as an employer, could have made significant contributions in excess of the mandatory minimum funding requirements for the ESOP. Third, the ESOP purchased extraordinarily valuable property that had been producing royalties in the millions of dollars since 1977. The ESOP was in exceptional financial condition by the end of the first year of its existence, and no plan beneficiary was placed at risk of losing benefits under the plan as a result to the prohibited transaction.

Given these circumstances, the higher court concluded that the prohibited transaction was corrected by the end of the 1981 taxable year. By that time, the statutory purposes of safeguarding the plan and its beneficiaries had been fulfilled. To have unraveled the prohibited transaction then would have placed the plan in a worse condition than if the disqualified persons had acted under the highest fiduciary standards.

Lessons to Be Learned

A respect for the confiscatory two-tiered excise tax is essential in the ESOP area. Prohibited transactions with ESOPs can cost a taxpayer an amount in excise taxes far greater than the amount of the original transaction. Taxpayers involved in transactions with ESOPS are advised to familiarize themselves with the ESOP rules concerning disqualified persons, prohibited transactions, corrections of such transactions, and the two-tier excise tax which is applicable to those transactions which remain uncorrected, even when the interests of the ESOP beneficiaries are enhanced by such a transaction. Taxpayers should also be aware of the special exemption from excise tax available from the Secretary of Treasury. Other courts may not be as lenient with taxpayers as the Eighth Circuit. Other courts may take the position of the Fifth Circuit: "The highest form of judicial restraint is resistance of the temptation to cure inartfully drafted legislation by indulging in judicial legislation."

D. Larry Crumbley, PhD, CPA, is Shelton Taxation Professor at Texas A&M University. Dianna Ross Coker, PhD, CPA, is assistant professor at Southwest Texas State University.

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