Law Office of John H. Eggertsen P.C. v. Comm'r, 14–2591.

• Decision Date: 08 September 2015
• Docket Number: No. 14–2591.,14–2591.
• Parties: LAW OFFICE OF JOHN H. EGGERTSEN P.C., Petitioner–Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

800 F.3d 758

LAW OFFICE OF JOHN H. EGGERTSEN P.C., Petitioner–Appellant

v.COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.

No. 14–2591.

United States Court of Appeals, Sixth Circuit.

Argued: Aug. 7, 2015.

Decided and Filed: Sept. 8, 2015.

ARGUED:Stephen F. Wasinger, Stephen F. Wasinger PLC, Royal Oak, Michigan, for Appellant. Francesca Ugolini, United States Department of Justice, Washington, D.C., for Appellee. ON BRIEF:Stephen F. Wasinger, Stephen F. Wasinger PLC, Royal Oak, Michigan, for Appellant. Francesca Ugolini, Bethany B. Hauser, United States Department of Justice, Washington, D.C., for Appellee.

Before: CLAY and SUTTON, Circuit Judges; WATSON, District Judge.^*

SUTTON, J., delivered the opinion of the court in which WATSON, D.J., joined, and CLAY, J., joined in part. CLAY, J. (pp. 766–68), delivered a separate opinion dissenting in part.

OPINION

SUTTON, Circuit Judge.

In the late 1990s, a law firm organized itself as a corporation and set up an employee stock ownership plan—what tax lawyers call an ESOP—to obtain favorable treatment under the Tax Code. In 2001, Congress amended the provisions, trying to squelch this tax strategy and giving affected taxpayers a grace period to come into compliance with the new rules. The law firm did not come into full compliance with the new amendments within the grace period. The IRS Commissioner took his time too. He waited until 2011 to try to collect the excise tax (over $200,000) that resulted from the firm's delayed compliance. At issue in this appeal are two questions: Do the 2001 amendments prohibit this tax strategy? Did the IRS wait too long to assess the tax? We hold that the law firm must pay the tax and affirm the Tax Court's decision to that effect.

I.

In 1998, John H. Eggertsen bought all of the outstanding shares of “J & R's Little Harvest, Inc.” and made several changes to the corporation. App. 46. The corporation filed an election to be treated as an S corporation for federal tax purposes. It changed its name to the less-quaint “Law Office of John H. Eggertsen, P.C.” Id. at 336. It established an ESOP, a type of retirement plan that primarily owns securities of the sponsoring employer. And Eggertsen transferred his ownership shares in the company to the ESOP and into an account allocated to himself. All of this meant that the law firm's ESOP became the sole owner of the shares of the S corporation Law Office.

Two features of the Tax Code explain the method to these changes. The first is that S corporations are not taxed at the corporate level; they pass their income through to shareholders who pay any tax due on that income. 26 U.S.C. § 1366. Once Eggertsen owned the Law Office's stock, any income earned by the Law Office would pass through to him and he would pay tax on it as individual income. The second is that, in the mid–1990s, Congress made it possible for ESOPs to own shares in S corporations and exempted S corporation ESOPs from taxes at the plan level. 26 U.S.C. §§ 501(a), 512(e)(3), 1361(b)(1)(B), 1361(c)(6)(B). ESOP participants, such as Eggertsen, are not taxed on income attributable to stock held in the ESOP until that stock is distributed to the participant, say, at retirement. Id. §§ 402, 409(a), 501(a) ; see generally Employee Benefits Law §§ 5.I, 6.I (Jeffrey Lewis et al. eds., 3d ed.2012). After these changes, the Law Office thus 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.

This arrangement sheltered considerable income from taxation. That of course does not make it wrong. No one has “a patriotic duty to increase [his] taxes,” and “[a]ny one may so arrange his affairs that his taxes shall be as low as possible.” Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir.1934) (Hand, L., J.), aff'd, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935). Just as individuals have no duty to pay more taxes than the law requires, however, Congress has no duty to preserve such shelters into perpetuity. Before long, legislators realized that “the income of an S corporation allocable to an ESOP” was totally exempt from “current taxation.” H.R.Rep. No. 107–84, at 274 (Conf.Rep.) (2001). That was especially grating given that the benefit often flowed to employees who were the least likely to need it. Many ESOPs, including Eggertsen's, did not have “broad-based employee coverage and [did not] benefit rank-and-file employees as well as highly compensated employees and historical owners.” Id. Congress responded in 2001. It imposed a 50% excise tax on S corporation ESOPs that violated new rules requiring broad-based employee ownership. 26 U.S.C. § 4979A. By Treasury regulation, this rule came into effect on January 1, 2005, for the Law Office's ESOP. Temp. Treas. Reg. § 1.409(p)–1T(i)(1)(ii) (2005). 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. 26 U.S.C. §§ 409(p)(2), 4975(e)(7). By Treasury regulation, this rule also came into effect on January 1, 2005, but the Law Office's ESOP had an additional six months (until June 30, 2005) to comply with respect to the pre–2005 allocation made to Eggertsen. Temp. Treas. Reg. § 1.409(p)–1T(i)(2)(iii)(A).

In response, the Law Office amended the ESOP in an attempt to mirror the new limits. And on June 30, 2005, the Law Office moved the stock allocated to Eggertsen to a non-ESOP account. See Temp. Treas. Reg. § 1.409(p)–1T(b)(2)(v) (permitting this change).

In 2006, the Law Office and the ESOP each filed 2005 tax returns. The Law Office's return noted that the ESOP owned 100% of the Law Office's stock. The ESOP's return, as amended, disclosed that the ESOP held $868,833 in assets, of which $401,500 was employer securities (the Law Office's stock). The Law Office believed it had complied with the new rules and so did not file a Form 5330, the return for the new excise tax.

In 2008, the IRS audited the Law Office to determine whether it owed the excise tax for 2005. The Law Office denied any such obligation over the next three years. In 2011, however, the Commissioner issued a deficiency notice, alleging that before the June 30, 2005, change, the ESOP was not in compliance with the excise tax rules and $200,750 of excise tax was due (50% of the $401,500 of Law Office stock held in the ESOP).

The Law Office challenged the deficiency in the Tax Court, disclaiming any tax due and claiming that the three-year statute of limitations barred the assessment. The Tax Court upheld the imposition of the tax but sided with the Law Office because the limitations clock had expired. The Commissioner moved for reconsideration. The court changed its mind. It held that the limitations period remained open and that the Law Office owed the excise tax.

II.

The Law Office raises three alternative arguments on appeal: (1) It does not owe any excise tax for 2005; (2) the three-year statute of limitations bars the assessment; and (3) the Tax Court should not have entertained the Commissioner's motion for reconsideration.

A.

Does the S corporation owe an excise tax? Section 4979A(a) imposes an S corporation ESOP-related excise tax in three settings: First, “[i]f ... there is any allocation of employer securities which violates the provisions of section 409(p),” 26 U.S.C. § 4979A(a)(3) ; second, “[i]f ... there is ... a nonallocation year described in subsection (e)(2)(C) with respect to an [ESOP], ” id. (emphasis added); and third, “[i]f ... any synthetic equity is owned by a disqualified person in any nonallocation year,” id. § 4979A(a)(4). If any of these circumstances apply, “there is hereby imposed a tax on such allocation or ownership equal to 50 percent of the amount involved.” Id. § 4979A(a). All agree that the first and third tax-triggering events do not apply here. No prohibited “allocation of employer securities” occurred in 2005, and no ownership of “synthetic equity”—primarily stock options, warrants, and the like, see id. § 409(p)(6)(C)—occurred in 2005. At issue is the second trigger italicized above and two questions prompted by it: Was 2005 a nonallocation year described in subsection (e)(2)(C) with respect to the Law Office's ESOP? And, if so, does that alone trigger the excise tax?

The Law Office and the IRS agree that 2005 was a nonallocation year. So do we.

That leaves the question whether this reality triggers the excise tax. It does. That is what the statute says. “If ... there is ... a nonallocation year described in subsection (e)(2)(C) with respect to an [ESOP],” to repeat, “there is hereby imposed a tax on such allocation or ownership equal to 50 percent of the amount involved.” Id. § 4979A(a). The words “such” and “ownership” in “such allocation or ownership” tell us what we need to know. The only way there can be a “nonallocation year” is if there is “ownership”: The definition of a “nonallocation year” requires that a specified set of persons “own at least 50 percent” of the relevant S corporation shares. Id. § 409(p)(3)(A)(ii). That is just what happened here—when Eggertsen failed to spread ownership of the S corporation among enough individuals.

The calculation of the excise tax reinforces the link between “nonallocation year” and “ownership.” The provision cross-referenced in the second trigger—subsection (e)(2)(C)—says that, during the first nonallocation year, the “amount involved” is set “by taking into account the total value of all the deemed-owned shares” of a defined set of persons. Id. § 4979A(e)(2)(C). To the extent the phrase “deemed-owned” does not explain the connection to ownership by itself, the Tax Code clarifies the point: “[A]n individual shall be treated as owning deemed-owned shares of the individual.” Id. § 409(p)(3)(B)(ii). Thus, not only is “nonallocation year” itself...