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Petersen v. Commissioner of Internal Revenue

United States Court of Appeals, Tenth Circuit

May 15, 2019


          Appeal from the United States Tax Court (CIR Nos. 015184-14 & 015185-14)

          Michael C. Walch, Kirton McConkie, Lehi, Utah, for Petitioners-Appellants.

          Jennifer M. Rubin (Bruce R. Ellisen, with her on the brief), Department of Justice, Tax Division, Washington, D.C., for Respondent-Appellee.

          Before HARTZ, PHILLIPS, and EID, Circuit Judges.


         This appeal concerns the propriety of the timing of deductions by a Subchapter S corporation for expenses paid to employees who participate in the corporation's employee stock ownership plan (ESOP). Stephen and Pauline Petersen and John and Larue Johnstun (Taxpayers) appeal the decision of the United States Tax Court holding them liable for past-due taxes arising out of errors in their income-tax returns caused by premature deductions for expenses paid to their Corporation's ESOP. Taxpayers contend that the Tax Court misinterpreted the Internal Revenue Code (IRC) and, even if its interpretation was correct, miscalculated the amounts of alleged deficiencies. The Commissioner agrees that a recalculation is necessary. Exercising jurisdiction under 26 U.S.C. § 7482(a), we affirm Taxpayers' liability but remand for recalculation of the deficiencies.

         I. BACKGROUND

         Taxpayers were majority shareholders in Petersen Inc. (the Corporation), a Subchapter S corporation.[1] The disputed liabilities arise from Taxpayers' income-tax returns for 2009 (offset in small part by corrections in their favor for their 2010 returns). Because the Corporation is a Subchapter S corporation, it is a pass-through entity for income-tax purposes-that is, the Corporation does not itself pay income taxes, but its taxable income, deductions, and losses are passed through to its shareholders. See 26 U.S.C. § 1366. For 2009 and most of 2010, Taxpayers owned 79.6% of the Corporation's stock. The remaining stock was held by the Corporation's ESOP. In October 2010 the ESOP acquired all of Taxpayers' stock, becoming the 100% owner.

         The ESOP is an employee-benefit plan governed by the Employee Retirement Income Security Act (ERISA). Employee-benefit plans that qualify under the detailed requirements of ERISA, see 26 U.S.C. § 401(a), are exempt from income taxes, see id. § 501. An ESOP is a type of qualified employee-benefit plan in which an employer contributes shares of its own stock, or cash to purchase shares of its stock, into a trust, and those shares are allocated to individual employee accounts. See 26 U.S.C. § 4975 (e)(7); 29 U.S.C. § 1107(d)(6); Donovan v. Cunningham, 716 F.2d 1455, 1459 (5th Cir. 1983). ESOPs provide employee participants the opportunity to gain ownership in shares of the employer corporation. As the Supreme Court has recently noted:

"The Congress, in a series of laws [including ERISA] has made clear its interest in encouraging [ESOPs] as a bold and innovative method of strengthening the free private enterprise system which will solve the dual problems of securing capital funds for necessary capital growth and of bringing about stock ownership by all corporate employees."

Fifth Third Bancorp v. Dudenhoeffer, 573 U.S. 409, 416 (2014) (quoting Tax Reform Act of 1976, § 803(h), 90 Stat. 1590 (brackets added by Supreme Court)). A corporation's contributions paid to its ESOP are tax deductible. See 26 U.S.C. § 404(a)(3); Brindle v. Wilmington Trust, N.A., 919 F.3d 763, 769 (4th Cir. 2019). There is no dispute that the Corporation's ESOP is qualified under ERISA.

         The Corporation is an accrual-basis taxpayer and its ESOP-participant employees are cash-basis taxpayers. As a general rule, an accrual-basis taxpayer may deduct ordinary and necessary business expenses in the year when "all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy." 26 U.S.C. § 461(h)(4). But § 267 of the IRC restricts the timing of deductibility when the accrued expense is to be paid to a cash-basis taxpayer that is "related to" the taxpayer. See id. § 267(a)(2). Such expenses cannot be deducted until the amount of the payment becomes gross income of the related taxpayer. See id. Consider, for example, an employee on the Corporation's payroll who is "related to" the Corporation (we will call such employees "related employees"), works during the last eight days of the calendar year, but does not receive a paycheck until early the following year. Although the Corporation accrues the payroll expense in the year that the employee worked the eight days, it must delay the deduction until the next year, when the related employee receives the payment of wages.

         Here, the Corporation deducted expenses for ESOP participants in the year that the expenses accrued even though it did not pay the expenses until the next year. Among those accrued expenses were wages and salaries (paid every second Friday) and unused vacation time rolled over by employees from one year to the next. If a payday fell early in January 2010, the Corporation could accrue during 2009 up to two weeks of unpaid payroll that the employee would not receive until 2010; and the expense of vacation days could be accrued many months before the employee used the benefit. These accrued but unpaid expenses should not have been deducted by the Corporation at the time of accrual if the payment would go to a related employee.

         The Internal Revenue Service (IRS) audited Taxpayers and decided that employees of the Corporation who participated in its ESOP were related to the Corporation. It therefore disallowed deductions taken for the 2009 tax year based on expenses accrued in that year but not paid to the related employees until 2010. Taxpayers unsuccessfully contested the alleged deficiencies in the United States Tax Court and now appeal to this court.


         "We review tax court decisions in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury. The Tax Court's legal conclusions are subject to de novo review, and its factual findings can be set aside only if clearly erroneous." Katz v. C.I.R., 335 F.3d 1121, 1125-26 (10th Cir. 2003) (citation and internal quotation marks omitted). We proceed to discuss the applicable statutory provisions and explain why the challenges by Taxpayers are unpersuasive.

         A. IRC § 267

         We begin with IRC § 267. Paragraph 267(a)(2) is entitled "Matching of deduction and payee income item in the case of expenses and interest." It provides that if the taxpayer and a person to whom the taxpayer is to make a payment are related-that is, "are persons specified in any of the paragraphs of subsection (b) [of § 267]," id. § 267(a)(1) (emphasis added)-then the amount of the payment cannot be deducted until it is paid or is includible in the recipient's gross income, see id. § 267(a)(2)[2]. This provision keeps taxpayers from exploiting differences in accounting methods between the payer (who deducts the payment) and the recipient (who treats the payment as income) to artificially evade, or at least delay, income taxes. It was enacted "to require related persons 'to use the same accounting method with respect to transactions between themselves in order to prevent the allowance of a deduction without the corresponding inclusion in income.'" Tate & Lyle, Inc. v. C.I.R., 87 F.3d 99, 103 (3d Cir. 1996) (quoting H.R. Supp. Rep. 998-432, Part 2, at 1578, reprinted in 1984 U.S.C.C.A.N. 697, 1205) (House Report); see also House Report at 1578-79 ("The failure to use the same accounting method with respect to one transaction involves unwarranted tax benefits, especially where payments are delayed for a long period of time, and in fact may never be paid."); Metzger Trust v. C.I.R., 76 T.C. 42, 75 (1981) (Congress enacted § 267 "to prevent the use of differing methods of reporting income for Federal income tax purposes in order to obtain artificial deductions for interest and business expenses."). For example, absent the limitations of § 267, an accrual-basis taxpayer indebted to a closely related cash-basis taxpayer could, as interest became due on the debt, report the interest as a deduction without making the payment to the cash-basis taxpayer, who would report no income at the time and might never report income if payment was arranged to arrive when the cash-basis taxpayer had offsetting losses. See Metzger Trust, 76 T.C. at 75.

         Subsection 267(b), entitled "Relationships," lists a number of relationships covered by this provision of the statute, such as "[m]embers of a family" and "[a] grantor and a fiduciary of any trust," 26 U.S.C. § 267(b)(1), (4). Relevant here, however, is subsection (e), which provides "[s]pecial rules for pass-thru entities." It states that "an S corporation [and] any person who owns (directly or indirectly) any of the stock of such corporation" are to be "treated as persons specified in a paragraph of subsection (b)." 26 U.S.C. § 267(e)(1) (emphasis added)[3]. In other words, an S corporation and a shareholder of that S corporation are related to one another for purposes of § 267. Because the Corporation ESOP owned much-later, all-of the shares of the Corporation, the Corporation and the Corporation ESOP were related.

         Also relevant here is § 267(c), entitled "Constructive ownership of stock." It provides, "For purposes of determining, in applying subsection (b), the ownership of stock-(1) Stock owned, directly or indirectly, by or for a corporation, partnership, state, or trust shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries." 26 U.S.C. § 267(c)(1) (emphasis added). If the stock held by an ESOP is held in a trust within the meaning of § 267(c)(1), and if the employees participating in the ESOP are beneficiaries of that trust, then the Corporation employees participating in the ESOP must be considered owners of stock of the Corporation under § 267(c). In our view, both of those conditions are met. To support that conclusion, we need to examine both trust law and ERISA.

         B. Trust ...

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