Substantial compliance no substitute for filing election.

A taxpayer's sale or exchange of investment securities generally does not qualify for nonrecognition of gain as a like-kind exchange. However, when taxpayers (other than C corporations) sell securities that they have held for at least three years in a C corporation that isn't publicly traded to an employee stock ownership plan (ESOP), they can elect not to recognize gain on the sale and reinvest the proceeds in replacement property. The nonrecognition of gain is temporary if the taxpayer subsequently disposes of the replacement property by other than a corporate reorganization, death or gift. Under a duly flied election, in the event of a taxpayer's death, the reproperty is included in his or her gross estate at fair market value, thus permanently avoiding federal income tax on the deferred gain.

To qualify for nonrecognition treatment, transfers must meet the requirements of IRC section 1042, Sales of Stock to Employee Stock Ownership Plans or Certain Corporations. Section 1042(a) provides for nonrecognition of gain if

(1) The taxpayer or executor elects in such form as the secretary of the Treasury may prescribe to apply this section to any sale of qualified securities.

(2) The taxpayer purchases qualified replacement property within the replacement period.

(3) The requirements of subsection (b) are met with respect to the sale.

Then the gain--if any--on the sale would be recognized as long-term capital gain only to the extent the amount realized on the sale exceeds the cost to the taxpayer of the qualified replacement property.

Treasury regulations section 1.1042-1T prescribes what form the required election not to recognize gain on the sale of qualified securities must take. It must be a written "statement of election" attached to the taxpayer's income tax return and filed on or before the due date (including extensions) for the taxable year in which the sale occurs. The domestic C corporation must consent to the application of IRC sections 4978 and 4979A in a written statement filed with the return. Taxpayers who fail to make a timely election cannot subsequently make it on an amended return. And once made, elections are irrevocable.

In 1995 John W. Clause retired from W.J. Ruscoe Co., a closely held C corporation. At that time he owned over 82% of the company's outstanding shares; he had been the majority shareholder since 1975. Clause did not acquire his shares from a plan distribution described in IRC section 401(a) or through a transfer under an option or other right to acquire stock.

At retirement Clause consulted with his accountant and an attorney the accountant believed was familiar with stock sales to ESOPs. The accountant had prepared Clause's tax returns since 1978 but had never prepared a return with a section 1042 transaction. The accountant also prepared the tax returns for W.J. Ruscoe Co.

On March 11, 1996, Clause sold all of his shares in Ruscoe to the company's ESOP for $1,521,630. He had owned these shares for more than three years and his basis at the time of the sale was $115,613. Clause deposited the sale proceeds into a brokerage account. On February 18, 1997, he purchased securities issued by domestic corporations, totaling $1,399,775, which satisfied the requirement of section 1042(c)(4) as "qualified replacement property."

While Clause timely filed his 1996 federal tax return, he did not report the sale of stock to the ESOP--in any manner--on the return. The original 1996 tax return did not include the statements of election and consent required under section 1042.

On November 28, 2000, during the IRS examination of Clause's original tax return, his accountant, acting under a power of attorney, filed an amended federal tax return for 1996 reporting a $121,807 gain, based on the amount Clause had not reinvested in qualified replacement property. On July 20, 2001, the IRS issued a notice of deficiency for 1996; it said Clause had not made a timely election under section 1042. Therefore, he must recognize $1,406,107 of long-term capital gain on the sale of stock to the ESOE 

Following receipt of the deficiency notice, Clause made further attempts to correct the situation. On October 17, 2001, he filed a second 1996 federal tax return--unchanged from the first attaching a statement of election under section 1042 predated to March 4, 1997, a statement from the company consenting to the application of sections 4978 and 4979A predated to March 4, 1997, and a statement of purchase of qualified replacement property predated to March 2, 1998. Clause's accountant filed a second amended federal tax return on October 29, 2001, also unchanged from the first except for the attachment of the statements of election and consent.

Clause argued that although he did not literally comply with the election requirements in the statute and regulation, he "substantially complied"; his failure to file the election was "purely administrative in nature" and therefore he should receive the benefits of section 1042. He cited several cases in which the court had held a taxpayer substantially complied with the requirements for an election even though the taxpayer had failed to meet the literal requirements: Bond v. Commissioner, 100 TC 32 (1993); Taylor v. Commissioner, 67 TC 1071, 1080; Hewlett-Packard Co. v. Commissioner, 67 TC 736, 748 (1977); Columbia Iron & Metal Co. v. Commissioner, 61 TC 5 (1973); Sperapani v. Commissioner, 42 TC 308 (1964); Cary v. Commissioner, 41 TC 214 (1963). Clause died on November 13, 2003; his estate substituted as petitioner.

In Estate of John W. Clause v. Commissioner, 122 TC no. 5, the court ruled there was no defense of substantial compliance for failure to comply with the essential requirements of section 1042. The "essence" of the statute is to demand evidence of a binding election to accept the tax consequences imposed by the section. The essence of a valid election was missing from Clause's original federal tax return since it included nothing to indicate the sale to the ESOP had even occurred.

Citing Dunavant v. Commissioner, 63 TC 316, 320 (1974), the court reiterated that it was not at liberty to infer an election existed when the unequivocal proof required by Congress did not exist. The court ruled each of the substantial compliance cases Clause had cited did not apply as in each the taxpayer's attempt to make the election was evident on the original tax return--that is, the taxpayer had provided most of the information required and the information missing was not significant. But Clause hadn't provided any of the information required by either the statute or the regulation regarding the ESOP transaction on his original tax return. The court also held Clause was not able to defer recognition of the gain resulting from the sale of stock to the ESOP.

Observation. Evidence of intent is an essential requirement to overcome a failure to file an election. Taxpayers can argue substantial compliance when they have provided most of the information required by the statute or regulations and the omitted information is not significant. Omitting income that otherwise would be excluded under a duly filed election from a tax return is not sufficient evidence of intent. The defense of substantial compliance generally will be unsuccessful in instances where the essential requirements of making the election clearly appear in the governing statute or regulations.

Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting, Christian Brothers University, Memphis, and Tina Quinn, CPA, PhD, associate professor of accounting, Arkansas State University, Jonesboro.