Zabolotny v. Comm'r of Internal Revenue, Docket No. 4844-87.

• Citation: 97 T.C. 385,97 T.C. No. 27
• Decision Date: 30 September 1991
• Docket Number: Docket No. 4844-87.
• Parties: ANTON ZABOLOTNY AND BERNEL ZABOLOTNY, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: United States Tax Court

97 T.C. 385
97 T.C. No. 27

ANTON ZABOLOTNY AND BERNEL ZABOLOTNY, Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 4844-87.

United States Tax Court

Filed September 30, 1991.

Petitioners owned a tract of land in North Dakota which they used for farming purposes. Oil was discovered under the land. Petitioners leased the mineral rights to Gulf Oil Corporation in return for sizable royalties. On May 20, 1981, petitioners incorporated their farming operation on the land. The corporation established an Employee Stock Ownership Plan (ESOP) for its employees. Petitioners then sold their initial interest in the land to the ESOP in exchange for payments to be received from a joint and survivor annuity plan established by the ESOP for the benefit of petitioners.

Respondent determined that the transactions between petitioners and the ESOP were prohibited transactions under sec. 4975(c), I.R.C. 1954, as added by the Employee Retirement Income Security Act of 1974 (ERISA), Pub. L. 93-406, tit. II, 88 Stat. 898, and determined deficiencies in excise taxes under sec. 4974(a) against petitioners.

HELD: (1) Petitioners were disqualified persons under sec. 4975(e), I.R.C. 1954.

(2) The real estate transactions entered into between petitioners and the ESOP were prohibited transactions under sec. 4975(c), I.R.C. 1954.

(3) The transactions were not exempt from the excise tax under secs. 406, 407 and 408 of ERISA and sec. 4975(d)(13), I.R.C. 1954.

(4) The prohibited transaction was not “corrected” within the meaning of sec. 4975(f)(5), I.R.C. 1954, by the fact that the transaction may have been favorable to the ESOP at its inception.

(5) Respondent's determinations of additions to tax pursuant to sec. 6651(a)(i), I.R.C. 1954, are incorrect since petitioners' failure to file the required excise tax returns was due to their reasonable reliance on the advice of their tax advisers that no taxable event had occurred for which such returns were required to be filed.

[97 T.C. 386]

Jill S. Rolek, for the petitioners.

William I. Miller and Judith M. Picken, for the respondent.

DRENNEN, JUDGE:

In notices of deficiency issued to both petitioners, respondent determined identical deficiencies in each of the petitioners' Federal excise taxes as follows:

+--------------------+
                ¦Anton Zabolotny ¦¦¦
                +------------------++¦
                ¦ ¦¦¦
                +--------------------+
                

 First-tier Additions to tax
                

Year (initial) deficiency sec. 6651 1
                1981 $324,095.75 $81,023.94
                1982 324,095.75 81,023.94
                1983 324,095.75 81,023.94
                1984 324,095.75 81,023.94
                1985 324,095.75 2 64,819.15
                1986 324,095.75 ---
                

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The Stipulation of Facts and the accompanying exhibits are incorporated herein by this reference.

Petitioners Anton and Bernel Zabolotny are husband and wife. They filed timely joint income tax returns for each of the years 1981 through 1986. At the time the petition in this case was filed, petitioners' legal residence was Killdeer, North Dakota. Before May 20, 1981, petitioners had been engaged in farming operations on 1,205 acres of land which they owned in Billings County and McKenzie County in

[97 T.C. 388]

western North Dakota. During the 1970's petitioners and other neighboring farmers discovered oil on their farm properties. In 1977, petitioners entered into various lease arrangements with Gulf Oil Corporation with respect to the mineral rights to their property. The oil production royalty rights on the property produced revenue in excess of $1 million to $1.5 million annually.

On May 20, 1981, Anton and Bernel Zabolotny and their son, Larry Zabolotny, incorporated petitioners' farming operation under the name Zabolotny Farms, Inc. (Farms, Inc.), in the State of North Dakota. ⁴ On the date of incorporation, Farms, Inc., issued 670 shares of its stock to both Anton and Bernel Zabolotny, which were the only shares issued as of that date. Starting on April 30, 1982, Anton and Bernel Zabolotny began to gradually transfer their stock in Farms, Inc., such that their overall percentage ownership of the corporation declined progressively to a combined total ownership of 6.97 percent of the stock of the corporation in 1985. The initial directors of Farms, Inc., were Anton Zabolotny, Bernel Zabolotny, and Larry Zabolotny. The officers of the corporation during all the years at issue were Anton Zabolotny, president; Larry Zabolotny, vice president; and Bernel Zabolotny, secretary-treasurer.

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. Sec. 4975(f)(5). Neither the majority nor respondent seems to question that this specific mandatory requirement was met. Thus, I think resolution of the issue turns on what Congress intended when it required that the prohibited transaction be undone “to the extent possible.”

[97 T.C. 408]

The term “possible” can encompass all that is capable of occurring without regard to rational limitations. However, the term “possible” can have a more limited meaning. “It is also sometimes equivalent to ‘practicable’ or ‘reasonable,’ as in some cases where action is required to be taken ‘as soon as possible.”’ Black's Law Dictionary 1166 (6th ed. 1990). I think it is clear that Congress used the term “possible” in this latter sense. Surely, Congress did not intend to require undoing a transaction without regard to the moral, ethical, legal, and rational consequences.

Petitioners, upon whom the majority would impose these extremely harsh results, were the very people whom the statute was intended to protect -- the beneficiaries of the ESOP. Petitioners continued to be the only beneficiaries of the ESOP for approximately 2 years after the transaction. During that time the net asset value of the ESOP increased by over $2 million even though only $1,500 had been contributed to it. The only source for this dramatic increase in value was the asset transferred in the prohibited transaction. Not only were the beneficiaries' interests safeguarded, they were substantially enhanced as a result of the transaction. ⁴ Once this became clear, nothing salutary could be accomplished by undoing the transaction under these unique circumstances. ⁵ The statutory objective of safeguarding the rights of the ESOP beneficiaries was achieved prior to December 31, 1981, and it was no longer rational to require a rescission.

A number of these conditions have not been satisfied. The fact that the farmland and oil royalty interests had been transferred to the trust does not appear to have been disclosed in the determination request; this was the omission of a material fact. The determination was not issued with respect to a prospective or proposed transaction; the trust had been formed and the property transferred to it 2 months before petitioners and the trust requested the determination, and more than 8 months before respondent issued the determination letter. Therefore, petitioners and

[97 T.C. 415]

the trust could not have relied to their detriment on respondent's determination that the trust was a qualified trust. Accordingly, respondent would be free retroactively to revoke his determination letter that the trust under the Plan was a qualified trust exempt from Federal income tax. ⁵

(2) Section 4975(e)(1) defines the term “plan” subject to the prohibited transactions taxes as

a trust described in section 401(a) which forms part of a plan * * * which trust or plan is exempt from tax under section 501(a), an individual retirement account described in section 408(a) or an individual retirement annuity described in section 408(b) * * * (or a trust, plan, account, or annuity * * *, which, at any time, has been determined by the Secretary to be such a trust, plan, account * * *). ⁶

Section 4975(e)(1) defines “plan” as a trust described in section 401(a). Since the parties here stipulated that the ESOP is such a trust, the first issue for our consideration is whether petitioners were “disqualified persons.” Section 4975(e)(2) defines “disqualified person” in terms of certain relationships a person has with a plan. ⁶ Those relationships include fiduciary, sec. 4975(e)(2)(A); an owner of 50 percent or more of a corporation any of whose employees are covered by the plan, sec. 4975(e)(2)(E); a member of the family of any individual described within certain paragraphs in section 4975(e)(2), sec. 4975(e)(2)(F); and any officer or director of a corporation which, among other things, has employees covered by the plan, sec. 4975(e)(2)(H).

Petitioner Anton Zabolotny was a disqualified person as described in section 4975(e)(2)(A), (E), and (H). As a trustee

[97 T.C. 392]

for the plan he had discretionary authority to manage the plan and was thus a fiduciary as described in section 4975(e)(3), ⁷ thus bringing him within section 4975(e)(2)(A). He was also a 50-percent shareholder of Farms, Inc., which was the corporation whose employees initially participated in the plan, thus bringing him within section 4975(e)(2)(E). Finally, as an officer of Farms, Inc., he falls within section 4975(e)(2)(H). Bernel, like Anton, as an officer and initial 50-percent shareholder of Farms, Inc., falls within section 4975(e)(2)(E) and (H). She is also, as Anton's wife, a family member as described in section 4975(e)(2)(F).

In Deluxe Check Printers, Inc. v. United States, 14 Cl. Ct. 782 (1988), revd. on other grounds sub nom. Deluxe Corp. v. United States, 885 F.2d 848 (Fed. Cir. 1989), the Claims Court recently rejected the Government's position that a “correction” within the meaning of section 4941(e) required the rescission of a self-dealing transaction. After rejecting the Government's argument, the Claims Court considered the taxpayer s argument that a correction occurred because the prohibited transaction was favorable to the private foundation. The Claims Court, however, found as a fact...