                              T.C. Memo. 2015-195



                         UNITED STATES TAX COURT



   DNA PRO VENTURES, INC. EMPLOYEE STOCK OWNERSHIP PLAN,
                          Petitioner v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 21047-14R.                        Filed October 5, 2015.



      Mark Eldridge (trustee), for petitioner.

      Pamela J. Sewell, for respondent.



                           MEMORANDUM OPINION


      DAWSON, Judge: In this declaratory judgment proceeding under section

74761 petitioner challenges respondent’s June 6, 2014, final nonqualification letter



      1
        Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect for the period under consideration, and all Rule references
are to the Tax Court Rules of Practice and Procedure.
                                        -2-

[*2] determining that for its plan year ending December 31, 2008, and its

subsequent plan years (2009 and 2010), the DNA Pro Ventures, Inc. Employee

Stock Ownership Plan (ESOP or plan) was not qualified under section 401(a) and

that the related trust was not exempt from taxation under section 501(a).

      The broad question before us is whether there was an abuse of discretion in

respondent’s determination. To decide that question, we consider whether the

ESOP: (1) exceeded the contribution limits under sections 401(a)(16) and 415(c);

and (2) failed to follow the plan terms by not obtaining a proper valuation of the

stock for any plan year. As explained hereinafter, we conclude that there was no

abuse of discretion in respondent’s determination.

                                    Background

      The parties filed a joint motion for leave to submit this case for decision

under Rule 122. We granted the motion and decide this case on the basis of the

pleadings and the stipulated administrative record. See Rule 217(b)(2). We

incorporate the stipulated record herein.

Advanced Orthopaedic Associates, P.A.

      Daniel J. Prohaska is a medical doctor and an orthopaedic surgeon

specializing in sports medicine, arthroscopy, and knee and shoulder surgery. He

worked with Advanced Orthopaedic Associates, P.A. (Advanced Orthopaedic),
                                         -3-

[*3] between 2008 and 2010. Advanced Orthopaedic paid Dr. Prohaska

compensation of $1,485,538, $1,601,100, and $1,822,000 for 2008, 2009, and

2010, respectively. During each year Dr. Prohaska deferred the maximum amount

allowable to the Advanced Orthopaedic section 401(k) plan.

DNA Pro Ventures, Inc.

      Dr. Prohaska was also involved with DNA Pro Ventures, Inc. (DNA), a

Kansas corporation, incorporated on November 12, 2008. At the time it filed its

petition, DNA had its principal mailing address in Iowa. DNA is the employer,

plan sponsor, and plan administrator of the ESOP.

      Dr. Prohaska and his wife, Amy, were DNA directors at the time of its

incorporation. Dr. Prohaska acted as DNA’s chairman and served as its president

and treasurer; Mrs. Prohaska served as DNA’s vice president and secretary. Dr.

and Mrs. Prohaska are DNA’s only employees.

The Plan

      On November 12, 2008, DNA created the ESOP for the benefit of its

employees. On November 28, 2008: (1) Dr. Prohaska signed the plan on behalf of

DNA and Ryan Eldridge signed it as trustee and (2) the ESOP and the trust were

amended in that Dr. Prohaska replaced Ryan Eldridge as trustee. The applicable

provisions of the plan are as follows:
                                       -4-

[*4] 1.10: “Compensation” means, with respect to any Participant and
     except as otherwise provided herein, such Participant’s wages as
     defined in Code Section 3401(a) and all other payments of
     compensation by the Employer * * * for a Calendar Year ending with
     or within the Plan Year (the “determination period”) for which the
     Employer is required to furnish the Participant a written statement
     under Code Sections 6041(d), 6051(a)(3) and 6052 (Form W-2
     wages). * * *

        *          *         *          *         *          *          *

      1.15: “Eligible Employee” means any Employee, except as provided
      below. The following Employees shall not be eligible to participate
      in this Plan:

           (a) Employees of Affiliated Employers, unless such Affiliated
      Employers have specifically adopted this Plan in writing.

            (b) Individuals who are not reported on the payroll records of
      the Employer as common law employees. * * *

            (c) Employees who are Leased Employees within the meaning
      of Code Sections 414(n)(2) and 414(o)(2).

             (d) Employees whose employment is governed by the terms of
      a collective bargaining agreement between Employee representatives
      * * * and the Employer * * *.

        *          *          *         *          *         *          *

      1.21: “Fiscal Year” means the Employer’s accounting year of 12
      months commencing on January 1st of each year and ending the
      following December 31st, except for the first Fiscal Year which
      commenced November 12th.

        *          *          *         *          *         *          *
                                        -5-

[*5] 1.46: “Plan Year” means the Plan’s accounting year of twelve (12)
     months commencing on January 1st of each year and ending the
     following December 31st, except for the first Plan Year which
     commenced November 12th.

         *         *          *          *          *          *          *

      1.61: “Year of Service” means the computation period of twelve (12)
      consecutive months, herein set forth, during which an Employee has
      at least 1000 Hours of Service. * * * in determining whether an
      Employee has completed a “Year of Service” for benefit accrual
      purposes in the short Plan Year, the number of the Hours of Service
      required shall be proportionately reduced based on the number of full
      months in the short Plan Year.

         *         *          *          *          *          *          *

      3.1: CONDITIONS OF ELIGIBILITY. Any Eligible Employee who
      was employed on the last day of the first Plan Year shall be eligible to
      participate and shall enter the Plan as of the first day of such Plan
      Year. Any other Eligible Employee who has completed one (1) Year
      of Service and has attained age 21 shall be eligible to participate
      hereunder as of the date such Employee has satisfied such
      requirements.

      3.2: EFFECTIVE DATE OF PARTICIPATION. An Eligible
      Employee shall become a Participant effective as of the earlier of the
      first day of the Plan Year or the first day of the seventh month of such
      Plan Year coinciding with or next following the date such Employee
      met the eligibility requirements of Section 3.1 * * *.

         *         *          *          *          *          *          *

      4.3(c): ALLOCATION OF CONTRIBUTION, FORFEITURES
      AND EARNINGS. The Company Stock Account of each Participant
      shall be credited as of each Anniversary Date with Forfeitures of
      Company Stock and the Participant’s allocable share of Company
                                        -6-

[*6] Stock (including fractional shares) purchased and paid for by the Plan or
     contributed in kind by the Employer. * * *

         *          *          *          *          *         *          *

      6.1: VALUATION OF THE TRUST FUND. The Administrator
      shall direct the Trustee, as of each Valuation Date, to determine the
      net worth of the assets comprising the Trust Fund as it exists on the
      Valuation Date. * * *

      6.2: METHOD OF VALUATION. Valuations must be made in good
      faith and based on all relevant factors for determining the fair market
      value of securities. * * * Company stock not readily tradeable on an
      established securities market shall be valued by an independent
      appraiser meeting requirements similar to the requirements of the
      Regulations prescribed under Code Section 170(a)(1).

DNA Actions

      On November 12, 2008, DNA issued: (1) 50 shares of class A common

stock to Dr. Prohaska in exchange for a $500 cash contribution and (2) 50 shares

of class A common stock to Mrs. Prohaska in exchange for a $500 cash

contribution. As of the date of issuance, the par value of the class A common

stock was $10 per share.

      On December 31, 2008, DNA issued 1,150 shares of class B common stock

to the trust with a par value of $10 per share. The trust then allocated the 1,150

shares of DNA stock to Dr. Prohaska’s ESOP account in 2008.
                                       -7-

[*7] During 2008 DNA did not pay any salaries, wages, or other officer’s

compensation. For 2009 DNA issued separate Forms W-2, Wage and Tax

Statement, to Dr. and Mrs. Prohaska reporting the respective amounts of $4,500

(during its fourth quarter beginning October 1). DNA issued Forms W-2 for 2010

to Dr. and Mrs. Prohaska reporting the respective amounts of $3,000.

      DNA deducted a $1,350 retirement plan contribution on its Form 1120, U.S.

Corporation Income Tax Return, for 2009.

      Although DNA was the sponsor of the ESOP, it did not file any Forms

5500, Annual Return/Report of Employee Benefit Plan, for plan years 2008, 2009,

and 2010.

      On August 10, 2012, the plan was amended to name Mark Eldridge trustee,

replacing Dr. Prohaska, and DNA then elected Mark Eldridge as an additional

DNA vice president.

Internal Revenue Service Examination of Plan and Determination

      In 2011 the Internal Revenue Service (IRS) began its examination of the

plan.2 On December 31, 2012, Revenue Agent Michael E. Talley sent Dr.

      2
       Several times, beginning September 13, 2011, the IRS requested (pursuant
to Form 4564, Information Document Request) DNA to provide numerous
documents relating to the examination of the plan (for the period November 12,
2008, through December 31, 2010): (1) participant allocation schedules,
                                                                     (continued...)
                                         -8-

[*8] Prohaska Form 886-A, Explanations of Items, determining that the ESOP was

not qualified under section 401(a) for the plan years ending December 31, 2008,

2009, and 2010. Any related trust was also determined not to be exempt from

taxation under section 501(a) for the same trust years.

      On June 6, 2014, respondent issued a final nonqualification letter, Letter

1757-A, to DNA explaining that the ESOP had failed to follow the terms set forth

in the plan documents and therefore was not qualified under section 401(a) and the

ESOP trust was not exempt from tax under section 501(a).

The nonqualification letter states in part as follows:

             In this case, the ESOP had two separate failures to follow its
      plan document during 2008. First, the ESOP sponsored by DNA Pro
      Ventures allowed Dr. Daniel J. Prohaska and Amy Prohaska to
      participate in the ESOP as of the plan year ending December 31,
      2008, in violation of the terms of the ESOP plan document regarding
      eligibility and participation. Second, the ESOP plan document
      required the ESOP to use appraisal rules substantially similar to those
      issued under I.R.C. sec. 170(a)(1) when it obtained annual appraisals
      for the same plan year. The ESOP, however, failed to obtain any
      appraisal for the 2008 plan year or for any plan year.

          *        *           *           *             *        *           *


      2
      (...continued)
(2) employee census reports, (3) participant account statements, (4) trustee or
administrator reports, ledgers, journals, or other financial reports, (5) copies of the
ESOP bank statements, and (6) copies of the independent appraisal reports.
However, DNA did not provide any of these requested documents.
                                        -9-

[*9]          During 2008, DNA Pro Ventures, Inc. transferred stock into the
       ESOP without consideration, and the stock accrued to the benefit of
       Dr. Prohaska (50%) and Mrs. Prohaska (50%). The value of the stock
       accruing to each participant, as reported by the ESOP, substantially
       exceeded 100% of each Dr. Prohaska’s and Mrs. Prohaska’s
       compensation from DNA Pro Ventures, Inc. for the year 2008. Thus,
       the ESOP failed to comply with I.R.C. secs. 401(a)(16) and 415 for
       the Plan Year ending December 31, 2008, and is not a qualified plan
       within the meaning of I.R.C. sec. 401(a) for the plan year ending
       December 31, 2008 and all subsequent plan years.

        *          *          *           *          *          *              *

              For the reason stated above, it is determined that the ESOP is
       not qualified under I.R.C. sec. 401(a) for the plan years ending
       December 31, 2008 and all subsequent plan years. As a result, the
       Plan is not exempt from taxation under I.R.C. sec. 501(a) for trust
       years ending December 31, 2008 and all subsequent plan years.

                                     Discussion

       Section 7476(a) authorizes this Court to render the requested declaratory

judgment, subject to the limitations of subsection (b). Neither party disputes that

those limitations have been met in this case, and we are satisfied that we have

jurisdiction over the petition. See, e.g., Efco Tool Co. v. Commissioner, 81 T.C.

976 (1983).

       In this declaratory judgment proceeding we review respondent’s

determination that the plan was not qualified. The standard for our review was
                                         - 10 -

[*10] enunciated in Buzzetta Constr. Corp. v. Commissioner, 92 T.C. 641, 648

(1989), as follows:

      When reviewing discretionary administrative acts, however, this
      Court may not substitute its judgment for that of the Commissioner.
      The exercise of discretionary power will not be disturbed unless the
      Commissioner has abused his discretion, i.e., his determination is
      unreasonable, arbitrary, or capricious. Whether the Commissioner
      has abused his discretion is a question of fact, and petitioner’s burden
      of proof of abuse of discretion is greater than that of the usual
      preponderance of the evidence. Estate of Gardner v. Commissioner,
      82 T.C. 989, 1000 (1984); Oakton Distributors, Inc. v. Commissioner,
      73 T.C. 182, 188 (1979).

Further, “[i]n order for a plan to be qualified, both its terms and its operations

must meet the statutory requirements.” Id. at 646.

      Respondent’s determination is presumed to be correct, and the burden of

proof is on petitioner. See Rule 142(a). To prevail, petitioner must prove that

respondent abused his discretion. See Buzzetta Constr. Corp. v. Commissioner, 92

T.C. at 648. Petitioner has failed to do so.

      Section 401(a) enumerates requirements which must be met in order for a

trust to be considered a qualified trust entitled to preferential tax treatment under

section 501(a). See Michael C. Hollen, D.D.S., P.C. v. Commissioner, T.C.

Memo. 2011-2, aff’d per curiam, 437 F. App’x 525 (8th Cir. 2011); Ronald R.

Pawlak P.C. v. Commissioner, T.C. Memo. 1995-7. Its terms and its operations
                                        - 11 -

[*11] must meet the statutory requirements. Buzzetta Constr. Corp. v.

Commissioner, 92 T.C. at 646. If a qualified plan meets all of the section 401(a)

requirements, then the plan is exempt from taxation under section 501(a). See

Michael C. Hollen, D.D.S., P.C. v. Commissioner, T.C. Memo. 2011-2. We need

not discuss specifically the qualification of the related trust under section 501(a)

because the exemption of the trust under section 501(a) follows from the

qualification of the plan under section 401(a). See id.

      A qualified plan must meet the section 401(a) requirements in both form

and operation. Ludden v. Commissioner, 620 F.2d 700, 702 (9th Cir. 1980), aff’g

68 T.C. 826 (1977); sec. 1.401-1(b)(3), Income Tax Regs. A form failure occurs

when a plan document does not contain required language or terms. See Michael

C. Hollen, D.D.S., P.C. v. Commissioner, T.C. Memo. 2011-2. An operational

failure occurs when: (1) a plan, in operation, does not meet the section 401(a)

requirements, see Martin Fireproofing Profit-Sharing Plan & Tr. v. Commissioner,

92 T.C. 1173 (1989), and (2) a plan fails to follow the terms of the plan document,

see Michael C. Hollen, D.D.S., P.C. v. Commissioner, T.C. Memo. 2011-2.

      In general, a qualification failure pursuant to section 401(a) is a continuing

failure because allowing a plan to requalify in subsequent years would be to allow

a plan “to rise phoenix-like from the ashes of such disqualification and become
                                       - 12 -

[*12] qualified for that year.” Pulver Roofing Co. v. Commissioner, 70 T.C. 1001,

1015 (1978); see also Martin Fireproofing Profit-Sharing Plan & Tr. v.

Commissioner, 92 T.C. at 1184-1189.

      As explained below, the ESOP failed to satisfy the section 401(a)

requirements in two separate ways, either of which is sufficient for the plan to not

be qualified. See secs. 401(a), 4975(e)(7). Clearly, respondent has not abused his

discretion.

Contribution Limits

      Section 401(a)(16) provides that a trust is not qualified if the plan “provides

for benefits or contributions which exceed the limitations of section 415.” For the

2008 plan year, a participant’s annual additions were limited to the lesser of

$40,000 or 100% of the participant’s compensation. See sec. 415(c)(1). Annual

additions are the sum of employer contributions, employee contributions, and

forfeitures. Sec. 415(c)(2). An allocation of stock to a participant’s account is an

employer contribution. Sec. 1.415(c)-1(b)(5), Income Tax Regs. “Participant’s

compensation” is “the compensation of the participant from the employer for the

year.” Sec. 415(c)(3)(A). A plan that allows contributions that exceed the

contribution limits of section 415 is not a qualified plan under section 401(a). See,

e.g., Van Roekel Farms, Inc. v. Commissioner, T.C. Memo. 2000-171, aff’d, 12
                                        - 13 -

[*13] F. App’x 439 (8th Cir. 2001). In addition, a section 415 failure is a

continuing failure that disqualifies the plan for a future year even when there is not

a separate, independent section 415 failure in the future year. Martin Fireproofing

Profit-Sharing Plan & Tr. v. Commissioner, 92 T.C. at 1184-1185.

      Neither Dr. Prohaska nor Mrs. Prohaska received any compensation for his

or her services as a DNA officer or employee during 2008. Accordingly, their

contribution limits were zero. Because DNA improperly transferred to Dr.

Prohaska’s ESOP account 1,150 shares of DNA’s class B common stock in 2008

(with a $10 par value per share), the annual addition to his account was $11,500

more than his contribution limit under section 415(c). Accordingly, because Dr.

Prohaska’s ESOP account received an annual addition in excess of the section

415(c) limitation, the ESOP failed the requirements of section 401(a)(16) and was

not a qualified plan for 2008. Moreover, because the section 415 failure is a

continuing failure, the ESOP failed section 401(a)(16) for 2008 and was not a

section 401(a) qualified plan for all subsequent plan years.

Failure To Obtain Appraisals

      Section 401(a)(28)(C) provides that in the case of an ESOP an “independent

appraiser” must perform all valuations of securities that are not readily tradable on
                                       - 14 -

[*14] an established securities market and that the standards for appraisers are

similar to those set forth in the regulations promulgated under section 170(a)(1).

      As set forth above, section 6.2 of the plan document requires a good-faith

valuation to determine the fair market value of the securities. Similarly, section

6.1 of the plan document requires that valuation of the trust fund be made on each

valuation date. Despite these requirements, the ESOP did not obtain any annual

appraisals in 2008, 2009, and 2010, resulting in an operational failure rendering

the ESOP not a section 401(a) qualified plan because the ESOP was not a “definite

written program”. See sec. 1.401-1(a)(2), Income Tax Regs. Moreover, because

the failure to follow the plan is a continuing failure, the ESOP was also not

qualified for the plan years ending December 31, 2009 and 2010.

      In sum, because the ESOP was not a qualified trust, it was not exempt from

tax pursuant to section 501(a) for any year.

Conclusion

      We conclude that there was no abuse of discretion in respondent’s

determination that the plan was not qualified under section 401(a) for its 2008 year

and subsequent plan years and that the trust was not exempt under section 501(a).

We so hold.

      Any contentions we have not addressed are irrelevant, moot, or meritless.
                                  - 15 -

[*15] To reflect the foregoing,


                                           Decision will be entered

                                  for respondent.
