On November 23, 2015, the U.S. Tax Court issued a declaratory judgment that the Internal Revenue Service (IRS) did not abuse its discretion in issuing a Letter of Revocation of the tax qualified status of the Fleming Cardiovascular, P.A. Employee Stock Ownership Plan (ESOP).
The Plan sponsor, Fleming Cardiovascular, P.A. (the “P.A.”) was formed in Wichita, Kansas by Dr. Robert Fleming on May 14, 2004. Two weeks later on May 28, 2004 the P.A. adopted an employee stock ownership plan, a tax qualified retirement plan intended to invest primarily in qualified employer securities. The ESOP purchased 5 shares of the P.A. stock on 12/30/04 for $50. On June 5, 2005 the IRS issued a favorable determination letter ruling that the Plan was tax qualified. As part of the application the P.A. indicated that there were two qualified employees employed by the P.A. at the time of the adoption who satisfied the one year and age 21 eligibility requirements. The president of the P.A., Dr. Fleming, allegedly began participating in the ESOP in 2004.
Upon investigation, the IRS determined (1) that the P.A. had failed to obtain independent certified appraisals of the company stock for plan years 2004, 2005, 2006, 2008, 2009 and 2010, an operational requirement for qualified ESOPs; (2) that the P.A. had failed to make recurring and substantial employer contributions to the retirement plan; (3) that annual additions to Dr. Fleming’s account exceeded the statutory annual limitations and (4) that individuals were allowed to participate who had not satisfied the Plan requirement of one completed year of service.
On August 29, 2012, the IRS sent a letter proposing to disqualify the ESOP on the basis of the above findings. In its defense, the P.A. indicated that the reason that there were no substantial ongoing contributions was that there were no employees for years 2004-2009 due to a court ordered non-compete injunction prohibiting the P.A. from engaging in the practice during the that period. Dr. Fleming began receiving a salary in 2010.
The largest issue appears to relate to a failed rollover from Dr. Fleming’s individual retirement account (IRA) in the amount of $408,543.00. Fleming alleged that this was rolled over into the ESOP and that the ESOP used the roll over funds to purchase 48.06 shares in 2005. Unfortunately, the ESOP never established a bank or brokerage account in 2004 or 2005 so there was no evidence of the receipt of a valid rollover from Fleming or his IRA custodian. There was a recorded cash distribution from Dr. Fleming’s IRA in 2004 however. All 53.06 shares were allocated to Dr. Fleming’s “rollover” subaccount in 2004 and 2005. On February 12, 2013 the IRS issued its final letter of revocation retroactive to 2004.
Tax Court Review
Based on the investigative record and written protest by the Plan sponsor, the Tax Court upheld the IRS revocation concluding:
(a) that Dr. Fleming received no compensation in 2004 and 2005, yet contrary to the Plan’s eligibility requirements, was allowed to participate and receive allocations of shares;
(b) that the Plan failed to meet a qualification requirement for employee stock ownership plans under Code Section 401(a)(28) because the stock was not valued at least annually by a qualified independent appraiser; and
(c) that there was no valid rollover, so the IRS properly treated the allocation of the 53.06 shares to Dr. Fleming in 2004 and 2005 as a violation of Code Section 415, as the stock allocation was in excess of 100% of Dr. Fleming’s compensation which was $0 in those two years.
As a consequence of these findings, Dr. Fleming will have taxable income due to the failed rollover for 2004 and income recognition due to the allocation of shares under a non-qualified trust (if vested). The trust will have taxable income as a non-exempt trust for the years 2004 forward.
We have written numerous blog articles concerning the risks in utilizing the business rollover technique known as “ROBS” (Roll Over for Business Startups). The Fleming Cardiovascular, P.A. case is just another example of how these business planning techniques can go wrong if all of the legal formalities are not completed and/or the qualification requirements not met.