                         T.C. Memo. 2011-2



                      UNITED STATES TAX COURT



          MICHAEL C. HOLLEN, D.D.S., P.C., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 19618-08R.             Filed January 4, 2011.



     Michael C. Hollen (an officer), for petitioner.

     Sarah S. Sandusky and Matthew M. Johnson, for respondent.



                        MEMORANDUM OPINION


     LARO, Judge:   Petitioner seeks a declaratory judgment under

section 7476 that its employee stock ownership plan (ESOP), the

Michael C. Hollen, D.D.S., P.C., Employee Stock Ownership Plan,

and its related employee stock ownership trust (ESOT) are
                                -2-

qualified under sections 401(a) and 501(a), respectively.1

Respondent determined that the ESOP and the ESOT did not qualify

under sections 401(a) and 501(a), respectively, for the plan year

ended October 31, 1987 (1987 plan year), and for all plan years

thereafter.   We sustain that determination.

                            Background

     The parties filed a joint motion for leave to submit this

case for decision under Rule 122.     We granted their motion and

decide this case on the basis of the pleadings and the stipulated

administrative record.   See Rule 217(a).    We incorporate the

stipulated record herein.

     Petitioner is a professional corporation that reports its

income and expenses on the basis of the calendar year.     It

employs its principal shareholder, Michael C. Hollen (Dr.

Hollen), as a dentist and as a corporate officer.     Its principal

place of business was in Iowa when the petition was filed.

     Petitioner began sponsoring the ESOP on November 1, 1986.2

The ESOP’s administrator is Dr. Hollen; he also is the ESOT’s

trustee.   The ESOP’s plan year initially ended on October 31 but



     1
      Unless otherwise noted, section references are to the
applicable versions of the Internal Revenue Code, and Rule
references are to the Tax Court Rules of Practice and Procedure.
     2
      The earliest plan document in the record is from Sept. 15,
1994. The record is unclear whether the plan applied for or
received a favorable determination letter from the Internal
Revenue Service at inception.
                                 -3-

was changed in 2001 to end on December 31.   As of its plan year

ended December 31, 2002, the ESOP had 15 participants and/or

beneficiaries.

     The ESOT’s primary asset was stock in petitioner.     On

October 12, 17, and 18, 1989, the ESOT borrowed a total of

$416,920 and used those proceeds to purchase a total of 130,696

shares of petitioner’s stock.    During the ESOP’s plan year ended

October 31, 1989 (1989 plan year), petitioner distributed

$200,000 to the ESOT, and the ESOT used the $200,000 to repay a

like amount of the borrowings.   In connection with that

repayment, the ESOT allocated $200,000 of petitioner’s common

stock to the accounts of the ESOP participants; $150,339 of that

allocation went to Dr. Hollen’s account.

     Petitioner retained Stephen Thielking (Thielking) as the

ESOP’s accountant.   Thielking is a certified public accountant,

and he appraised the stock held by the ESOT in 2001, 2002, and

2003.

     On January 1, 2001, the ESOP was amended effective as of

that date.   On December 27, 2002, petitioner requested a

determination from the Commissioner as to the qualified status of

the ESOP as amended in 2001.    Petitioner withdrew that request on

August 4, 2003.   On May 15, 2008, the Commissioner issued a final

nonqualification letter, which underlies this proceeding.
                                  -4-

                            Discussion

     Section 7476(a) authorizes this Court to render the

requested declaratory judgment, subject to the limitations of

section 7476(b).   Neither party argues that any of those

limitations is not met, and we are satisfied that we have

jurisdiction over the petition.    See generally Efco Tool Co. v.

Commissioner, 81 T.C. 976 (1983) (discussing this Court’s

jurisdiction in the setting of a declaratory judgment case such

as this).

     Respondent determined that the ESOP and the ESOT failed to

qualify under sections 401(a) and 501(a), respectively, because:

(1) The ESOP was not timely amended to include provisions

required by sections 402(c)(4)(C), 414(n)(2)(C), (q), and (u),

and 415(c)(3); (2) the ESOP failed to follow the vesting schedule

required by section 411(a)(2)(B); (3) the ESOP failed to use an

independent appraiser to appraise employer securities as required

by section 401(a)(28)(C); and (4) the beneficiary account of Dr.

Hollen exceeded the allowable amount of annual additions for the

1989 plan year.

     Respondent’s determination is presumed to be correct, and

the burden of proof is on petitioner.3    See Rule 142(a); Welch v.


     3
      In certain cases, sec. 7491(a)    places the burden of proof
on the Commissioner “with respect to    any factual issue relevant
to ascertaining the liability of the    taxpayer for any [Federal
income or estate] tax”. We need not     decide whether sec. 7491(a)
                                                      (continued...)
                                  -5-

Helvering, 290 U.S. 111, 115 (1933).    To prevail, petitioner must

prove that respondent abused his discretion.   Under this

standard, petitioner must persuade the Court that respondent’s

determination was unreasonable, arbitrary, or capricious.    See

Buzzetta Constr. Corp. v. Commissioner, 92 T.C. 641, 648 (1989).

Petitioner has failed to do so.

     Section 401(a) lists 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 generally

Ronald R. Pawlak, P.C. v. Commissioner, T.C. Memo. 1995-7

(discussing the types of preferential tax treatment under section

501(a)).   In addition, the Employee Retirement Income Security

Act of 1974, Pub. L. 93-406, sec. 402(a)(1), 88 Stat. 875,

requires that the plan be in writing.   See also sec.

1.401-1(a)(2), Income Tax Regs.    Congress established the writing

requirement so that every employee may, on examining the plan

document, determine exactly what his or her rights and

obligations are under the plan and who is responsible for

operating the plan.   See Curtiss-Wright Corp. v. Schoonejongen,

514 U.S. 73, 83 (1995); H. Conf. Rept. 93-1280, at 297 (1974),



     3
      (...continued)
applies to declaratory judgment actions such as this. This is
because sec. 7491(a) is not applicable where, as here, the
taxpayer makes no argument as to the applicability of the section
and fails to show that the prerequisites for its applicability
have been met.
                                -6-

1974-3 C.B. 415, 458.   With these basic principles in mind, we

turn to analyzing respondent’s determination as to the ESOP’s

qualification under section 401(a).   We do not specifically

discuss the qualification of the ESOT under section 501(a)

because the exemption of the ESOT under section 501(a) follows

from the qualification of the ESOP under section 401(a).    See

Ronald R. Pawlak, P.C. v. Commissioner, supra.

Disqualifying Reason 1:   ESOP Not Properly Amended

     The Small Business Job Protection Act of 1996, Pub. L.

104-188, 110 Stat. 1755, and the Internal Revenue Service

Restructuring and Reform Act of 1998, Pub. L. 105-206, 112 Stat.

685, amended the plan qualification requirements under sections

402(c)(4)(C) (eligible rollover distributions), 414(n)(2)(C)

(definition of employee leasing), 414(q) (definition of highly

compensated employee), 414(u) (special rules for veterans), and

415(c)(3)(D) (participants’ compensation).   Respondent determined

that the ESOP did not qualify under section 401(a) because it was

not timely amended to reflect these laws.

     Petitioner did not amend the ESOP in accordance with the

effective dates set forth in the referenced statutes.   All the

same, the ESOP may retroactively qualify under section 401(a) if

remedial amendments were made during the remedial amendment

period described in section 1.401(b)-1, Income Tax Regs.    That
                                       -7-

section provides that a plan such as the ESOP may qualify

retroactively if:

     on or before the last day of the remedial amendment
     period * * * with respect to such disqualifying
     provision, all provisions of the plan which are
     necessary to satisfy all requirements of sections
     401(a), 403(a), or 405(a) are in effect and have been
     made effective for all purposes for the whole of such
     period. * * * [Sec. 1.401(b)-1(a), Income Tax Regs.]

For this purpose, the last day of the remedial amendment period

is determined by reference to section 1.401(b)-1, Income Tax

Regs.     In accordance with that section and with Rev. Proc.

2001-55, 2001-2 C.B. 552, the last day of the remedial amendment

period at issue was February 28, 2002.4

        The chart below shows the effective dates for sections

402(c)(4)(C), 414(n)(2)(C), (q), and (u), and 415(c)(3)(D), the

dates on which the ESOP adopted its related amendments, and the

dates on which the ESOP made each of those amendments effective.

                       Required              Amendment        Amendment
                       Effective             Adopted          Effective
        Section          Date                  Date             Date

   402(c)(4)(C)      Jan.   1, 1999      Jan.   1,   2001   Jan.   1,   2001
   414(n)(2)(C)      Nov.   1, 1997      Jan.   1,   2001   Jan.   1,   2001
   414(q)            Nov.   1, 1997      Jan.   1,   2001   Jan.   1,   2001
   414(u)            Dec.   12, 1994     Jan.   1,   2001   Jan.   1,   2001
   415(c)(3)(D)      Dec.   31, 1997     Jan.   1,   2001   Jan.   1,   2001




     4
      The remedial amendment period extension provision of sec.
1.401(b)-1(e)(3), Income Tax Regs., does not apply because
petitioner requested the determination letter on Dec. 27, 2002,
after the remedial amendment period expired.
                                  -8-

     Although the ESOP adopted its amendments on January 1, 2001,

before the expiration of the remedial amendment period, the

amendment failed to make the provisions effective as of the

required effective dates.     The ESOP is therefore not qualified

under section 401(a) because the required provisions failed to be

effective for the whole of the remedial amendment period.      See

sec. 1.401(b)-1, Income Tax Regs.; see also Ronald R. Pawlak,

P.C. v. Commissioner, supra.

Disqualifying Reason 2: Certain Plan Participants Not Credited
According to Vesting Schedule

     Section 401(a)(7) requires that the ESOP satisfy the vesting

requirements of section 411.     Section 411(a)(2)(B)(iii) provides

for a vesting schedule whereby an employee vests in plan benefits

over a period of 6 years, pro rata.     The ESOP’s plan document

reflects the vesting schedule required by law, but the ESOP in

operation did not follow that schedule.     The following chart

shows the vesting percentages reflected in the ESOP’s records

compared with those required under section 411(a)(2).5

                  Vesting Percentage          Vesting Percentage
   Employee        Per Plan Records     Required Under Sec. 411(a)(2)

  Ann Tarr              -0-                          80
  Susan Bess            40                          100
  Jodi Robinson         20                           -0-
  Cynthia Dunn          -0-                          40
  Kerry Newland         -0-                          20
  Sarah Wheeter         -0-                          40


     5
      Petitioner claims that “any required corrections have been
made”, but the record does not substantiate this claim.
                                 -9-

     The ESOP fails to qualify under section 401(a) because it

did not properly vest in operation in accordance with the

schedule required by the plan.   See sec. 1.401-1(b)(3), Income

Tax Regs. (stating that “The law is concerned not only with the

form of a plan but also with its effects in operation”); see also

Winger’s Dept. Store, Inc. v. Commissioner, 82 T.C. 869, 876

(1984) (stating that “the operation of the trust is as relevant

as its terms”); Quality Brands, Inc. v. Commissioner, 67 T.C.

167, 174 (1976) (holding to the same effect).   Petitioner offers

no explanation as to why the vesting schedules on the ESOP’s

books did not properly reflect the provisions of the plan

document’s vesting schedule.   Moreover, petitioner declined

respondent’s offer to participate in a closing agreement program

(CAP) which would allow for retroactive compliance.   Because the

ESOP was not operationally in compliance, we hold that it failed

the requirements of section 411 (and hence section 401).

Disqualifying Reason 3:   ESOP Failed To Use Independent Appraiser

     Petitioner asserts that Thielking was a permissible

appraiser of the ESOT’s stock in petitioner.    We hold otherwise.

Section 401(a)(28)(C) provides that all employer securities which

are not readily tradable on an established securities market must

be valued by an “independent appraiser”.   Since petitioner’s

stock is not traded on an established securities market, an

independent appraiser had to value the ESOT’s holdings of that
                               -10-

stock.   As relevant here, an “independent appraiser” means a

“qualified appraiser” as defined by section 1.170A-13(c)(5)(I),

Income Tax Regs.

     The ESOP fails at least two requirements of that section.

First, section 1.170A-13(c)(5)(i), Income Tax Regs., requires

that the appraisal summary contain a declaration that the

individual holds himself out to the public as an appraiser.     The

appraisal letters covering the 2001 through 2003 plan years state

that “The undersigned holds himself out to be an appraiser”.

However, there is no signature below that statement on any of the

letters (there is an unsigned line for a signature with the word

“appraiser” typed below).   Second, section 1.170A-13(c)(3)(ii)(F)

and (5)(i)(B), Income Tax Regs., requires that the qualified

appraiser who signs the appraisal must list his or her

background, experience, education, and membership, if any, in

professional appraisal associations.   The appraisal here is not

signed, and the appraisal summary does not list the referenced

information.

     We conclude that the ESOT’s holdings of petitioner’s stock

were not valued by a “qualified appraiser” and that the ESOP

therefore fails the requirements of section 401(a)(28)(C) (and

hence section 401(a)).   Petitioner does not assert that the

substantial compliance doctrine applies.   See Bond v.

Commissioner, 100 T.C. 32 (1993).
                                -11-

Disqualifying Reason 4:    Excess Annual Additions Allocated to Dr.
Hollen

     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 1989 plan year, a

participant’s annual additions were limited to the lesser of

$30,000 or 25 percent of the participant’s compensation.    See

sec. 415(c)(1).

     The parties dispute whether respondent properly

recharacterized $150,339 of the $200,000 dividend paid to the

ESOP as an annual addition subject to the limitations of section

415(c).   The term “annual addition” includes employer

contributions, employee contributions, and forfeitures.    See sec.

415(c)(2).   The term generally does not include a dividend on

employer stock distributed to an employee stock ownership plan

which uses the distributed proceeds to pay interest and principal

on an employer securities acquisition loan.   See id.; see also

sec. 404(a)(9).   Section 1.415-6(b), Income Tax Regs., however,

recognizes that certain transfers to such a plan, although not

labeled as a contribution or forfeiture, may in fact be an annual

addition.    To combat such abuse, section 1.415-6(b)(2)(i), Income

Tax Regs., allows the Commissioner “in an appropriate case,

considering all of the facts and circumstances, [to] treat

transactions between the plan and the employee or certain
                                 -12-

allocations to participants’ accounts as giving rise to annual

additions.”   Respondent treated $150,339 of the $200,000 dividend

as such an annual addition to Dr. Hollen’s account.

     We review that determination for abuse of discretion, and we

find none.    Dr. Hollen was the primary beneficiary of the

$200,000 dividend distributed to the ESOT and of the ESOT’s use

of those proceeds to repay a like amount of the borrowings

obtained to purchase the stock of petitioner.   That repayment was

of funds borrowed by the ESOT to buy $200,000 of common stock

held by the ESOT, approximately 75 percent of which was allocated

to the account of Dr. Hollen.    The effect of the financing, which

was proximate to the distribution, was to provide petitioner with

a deduction for the principal payments on the loans, see sec.

404(a)(9)(A), without any corresponding income recognition by

either petitioner or the ESOT.    This in turn increased the value

of the stock held by the ESOT (primarily to Dr. Hollen’s benefit)

by the value of the income tax savings.   Given these facts, we do

not believe that respondent abused his discretion when he

recharacterized the $150,339 in “earnings” allocated to Dr.

Hollen as an annual addition.    See Steel Balls, Inc. v.

Commissioner, T.C. Memo. 1995-266, affd. without published

opinion 89 F.3d 841 (8th Cir. 1996).

     We conclude that the ESOP failed the requirement of section

401(a)(16) for the 1989 plan year because Dr. Hollen’s ESOT
                                -13-

account received an annual addition in excess of the limitations

of section 415(c).    Because the ESOP never took any action to

correct this failure, the ESOP also was not qualified in plan

years after that date.   See Clendenen v. Commissioner, T.C. Memo.

2003-32, affd. 345 F.3d 568 (8th Cir. 2003); see also Martin

Fireproofing Profit-Sharing Plan & Trust v. Commissioner, 92 T.C.

1173, 1184 (1989) (stating that “corrective action of the sort

set forth in the regulations is a prerequisite to requalification

of a trust, following a violation of section 415”).      Petitioner

had the opportunity to correct this failure through the CAP but

chose not to do so.   We hold that the ESOP is disqualified for

1989 and for all subsequent plan years.

                             Conclusion

     We sustain respondent’s determination that the ESOP and ESOT

were disqualified for the 1987 plan year and for all plan years

thereafter.6   We have considered all arguments made by petitioner

for holdings contrary to those expressed herein and reject these

arguments not discussed herein as irrelevant or without merit.

     Accordingly,


                                            Decision will be entered

                                       for respondent.


     6
      We uphold respondent’s determination that the ESOP was
disqualified for the 1987 and 1988 plan years because there is no
plan document in the record for those years.
