No gain deferral on stock sale to ESOP.

• Author: Puckett, Mark D.
• Position: Employee stock ownership plan

A taxpayer who sold his closely held corporation stock to an employee stock ownership plan (ESOP) was unable to defer gain recognition from the sale due to his failure to make a valid Sec. 1042 election. In Est. of John W. Clause 122 TC No. 5 (2/9/04), the Tax Court held that the doctrine of substantial compliance was inapplicable and did not relieve the taxpayer of the deficiency.

Clause is of interest not just because it teaches how not to obtain the benefits of a Sec. 1042 deferral, but also because it revisits the doctrine of substantial compliance.

Background

Several Code sections and their regulations require certain elections, informational statements and other specific actions on the part of taxpayers to obtain desired tax consequences. Some of these required "actions" are unambiguously set forth in the statutes; others are statutorily delegated to Treasury to carry out the statute's substance. Sec. 1042 is a prime example of a statute requiring certain actions on a taxpayer's part, including a Sec. 1042(a)(1) election that is to be "... in such form as the Secretary may prescribe.... "

What happens when a taxpayer fulfills most, but not all, of the necessary actions in the manner and form required? The doctrine of substantial compliance may apply.

The Tax Court has indicated that "... there exists no litmus test for determining whether literal compliance with a procedural regulation is called for ..." (Hewlett-Packard Co., 67 TC 736, 748 (1977)). Rather, a review is required to determine whether literal compliance is needed. The purpose and terms of the underlying statute, as well as the consequences of a failure to comply with the relevant provision, must be taken into account; see Octavio J. Valdes, 60 TC 910 (1973). Going as far back as 1928, the Board of Tax Appeals framed the question as "... [w]hat is the essence of the thing required to be done by this statute?" (Indiana Rolling Mills Co., 13 BTA 1141 (1928)). Lastly, the doctrine can cut both ways; it has been invoked by both taxpayers and the Service alike.

Facts

For nearly 40 years, John Clause worked for W.J. Ruscoe Co., a closely held corporation. In 1996, a year after his retirement, he sold all of his Ruscoe stock to an ESOP established by the company, for $1,521,630. Within a year of the sale, he purchased "qualified replacement property," which met the Sec. 1042(c)(4) requirements, totaling approximately $1.4 million, leaving only $120,000 of unreinvested proceeds.

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