Sec. 1042 recapture gain determined under installment method

The Tax Court held that, where gains have been deferred under Sec. 1042 on a stock sale to an employee stock ownership plan (ESOP), the installment method in Sec. 453 applies in determining the amount of deferred gain that must be recaptured under Sec. 1042(e) when there is a sale of qualified replacement property (QRP) purchased to meet the requirements for Sec. 1042 gain deferral.

Background

Edward Berman and his cousin Annie Berman in 2002 each owned 50% of the stock in E.M. Lawrence Ltd. E.M. Lawrence established the E.M. Lawrence Employee Stock Ownership Plan (the ESOP) on Sept. 1, 2002.

On Nov. 8, 2002, the Bermans sold E. M. Lawrence stock to the ESOP. They both received a $4.15 million promissory note from the ESOP in exchange for their shares. No payment was made on the promissory notes in 2002, and a first payment of $449,277 was made to each of them in 2003.

On their tax returns for 2002, the Bermans elected to defer the approximately $4.122 million of gain from the sale of the stock to the ESOP under Sec. 1042, which generally permits an electing taxpayer to defer recognition of gain realized on the sale of stock to an ESOP, provided the taxpayer acquires QRP with the proceeds from the sale within a 12-month period. On their 2003 returns, the Bermans reported that they had acquired the requisite amount of QRP during the applicable replacement period, ostensibly qualifying them to defer the full amount of gain.

However, in 2003, the Bermans had also pledged their QRP as collateral in “Derivium 90%” loan transactions. The Tax Court has held in numerous cases that the purported loans in this type of transaction and other similar ones are not loans but are instead sales of the property used as collateral for the loans. Thus, as the Bermans later conceded, their pledges of their QRP as collateral were sales of the QRP. Under Sec. 1042(e), the sale of QRP triggers a recapture of a taxpayer’s previously deferred gain under Sec. 1042. Accordingly, the Bermans’ deferred gain from their sales of their stock to the ESOP was recaptured in 2003.

The IRS issued notices of deficiency to the Bermans for 2003. The notices determined that because of their sales of their QRP, the Bermans had unreported long-term capital gain in 2003 of $4.122 million each, which was the entire amount of their gain on their sales of stock to the ESOP that they had reported as deferred for both 2002 and 2003. The Bermans challenged the IRS’s determinations in Tax Court.

In Tax Court, the Bermans argued that they did not make valid Sec. 1042 elections, so Sec. 1042 did not apply to the sales of the stock to the ESOP. They also argued that if the elections were determined to be valid, because the sales of stock to the ESOP in 2002 were installment sales, they were entitled to report the gains triggered under Sec. 1042(e) by the 2003 sales of the QRP under the installment method in Sec. 453.

The IRS in turn argued that the Bermans had made valid elections under Sec. 1042 with respect to the stock sales to the ESOP. Thus, the timing and amount of the gain that the Bermans were required to recognize in 2003 were governed by Sec. 1042(e), and Sec. 453 had no relevance. Under Sec. 1042(e), the full amount of gain from the sales that had been deferred under Sec. 1042(a) was required to be recaptured and recognized in 2003 when the Bermans sold their QRP.

The Tax Court’s decision

The Tax Court held, as the IRS argued, that the Bermans made valid Sec. 1042 elections in 2002 to defer the gains on their sales of stock to the ESOP in that year. The court further held, though, as the Bermans had argued, that having not elected out of the installment method for the 2002 stock sales and having made valid Sec. 1042 elections to defer the gain on those sales, the recapture gain that they must recognize in 2003 due to the sale of their QRP should be determined under the installment method.

Sec. 1042 election: A valid Sec. 1042 election can only be made for a sale of C corporation stock. The Bermans first argued that their Sec. 1042 elections were not valid because E.M. Lawrence was an S corporation rather than a C corporation at the time of the sales of the stock in the corporation to the ESOP. However, the IRS argued that because the Bermans had represented on their 2002 returns that E. M. Lawrence was a C corporation, under the duty of consistency, they were precluded from taking the position in Tax Court that the corporation was an S corporation at the time of the stock sale.

The duty of consistency is an equitable doctrine that prevents a taxpayer from taking one position on a tax return and later taking a contrary position after the statute-of-limitation period has run on that year, if the contrary position would harm the IRS. The Tax Court found that the Bermans had consistently represented on their 2002 returns and afterward that E.M. Lawrence was a C corporation at the time of the stock sales to the ESOP, that the IRS had relied on the representations on the returns, and that the statute of limitation on the 2002 tax year had passed, so that the IRS, to its detriment, could no longer challenge the validity of the Bermans’ 2002 Sec. 1042 elections. Thus, the duty of consistency applied, and the Bermans were estopped from claiming that E.M. Lawrence was an S corporation and not a C corporation at the time of their stock sales to the ESOP.

The taxpayers’ second argument was that, even if their Sec. 1042 elections were invalid, they could revoke them. The IRS argued that their elections were irrevocable under the regulations.

Besides finding that the Bermans’ Sec. 1042 elections were irrevocable under Temp. Regs. Sec. 1.1042-1T, Q&A-3(a), the Tax Court found that the IRS’s position that the election was irrevocable was supported by the doctrine of election, which holds generally that an election by a taxpayer that is a free choice between alternative, legally valid tax treatments and is communicated to the IRS by an overt act is irrevocable. Determining that the Bermans met all the requirements for applying the doctrine, the court concluded that the taxpayers’ elections were irrevocable.

According to the Bermans, even if their Sec. 1042 elections generally were irrevocable, they were still entitled to revoke them because they were based on a material mistake of fact. The Bermans contended that the material mistake of fact was regarding the value of the promissory notes they received in the sale of their stock to the ESOP. As support for this position, they relied on the Fifth Circuit’s holding in Meyer’s Estate, 200 F.2d 592 (5th Cir. 1952), rev’g 15 T.C. 850 (1950). However, the court found that the mistake of fact about the value of the promissory notes was readily distinguishable from the mistake of fact in Meyer’s Estate. Thus, the court concluded that the Bermans were not entitled to revoke their elections based on a material mistake of fact.

Application of installment method: Having decided that the Bermans’ elections under Sec. 1042 were valid, the Tax Court then considered whether they were entitled to recognize the gains recaptured under Sec. 1042(e) due to the sales of their QRP under the installment method in Sec. 453.

The IRS argued that because the Bermans made a valid Sec. 1042 election to defer the gains on their sales of stock to the ESOP on their 2002 returns, no gain was left on which Sec. 453 could operate. According to the IRS, Sec. 1042(e) was the exclusive means for determining the amount of gain taxpayers must use when they dispose of QRP because Sec. 1042(e) states that it applies “notwithstanding any other provision” of the Code.

The Tax Court found the IRS’s argument that a Sec. 1042 election overrides Sec. 453 “ignores the plain text of section 453,” which states that, unless otherwise provided by Sec. 453, income from installment sales must be taken into account for purposes of the Code under the installment method. This command in Sec. 453, the court found, is “as sweeping” as the command in Sec. 1042(e) that, upon the disposition of QRP, the gain recaptured on a sale of stock to an ESOP must be determined under that section.

The Tax Court found that under Sec. 453(b)(1), the Bermans’ sales of stock to the ESOP were installment sales because at least one payment for the stock was to be received after the close of the tax year in which the sale occurred. Because Sec. 453 presumptively applies unless a taxpayer opts out of it, and the Bermans had not opted out of it with respect to their 2002 sales of stock to the ESOP, the court found that Sec. 453 applied to those sales. Because, as the court had previously determined, the Bermans had also made a valid Sec. 1042 election, their sales of ESOP stock were subject to the rules of both Sec. 453, regarding installment sales, and Sec. 1042, regarding the deferral of gain on the sale of stock to an ESOP.

The court further found that “a careful parsing” of Sec. 1042 showed that it could be reconciled and harmonized with Sec. 453. The provision, in the flush language of Sec. 1042(a), states that deferral applies to the gain (if any) on a sale of stock to an ESOP “which would be recognized as longterm capital gain.” According to the court, the use of the subjunctive phrasing concerning gain “which would be recognized” raised the question of “what gain would be recognized on the sale of the qualified securities in the absence of a section 1042 election?”

Given that the enactment of the flush language in Sec. 1042(a) followed the enactment of the current version of Sec. 453 by six years, the court found that Congress is presumed to have been aware of the operation of Sec. 453 when it enacted the flush language. Therefore, the court concluded that Congress is presumed to have been aware that the gain that “would be recognized” (i. e., the gain that would otherwise be recognized in the absence of Sec. 1042) could depend upon the operation of Sec. 453 if stock for which a Sec. 1042 election was made had been sold pursuant to an installment sale.

Consequently, the Tax Court held that the Bermans were entitled to recognize the gain on their sale of stock to the ESOP, which they were required to recapture in 2003 under Sec. 1042(e) due to the sale of their QRP, under the installment method in Sec. 453. The court further held that the gain that the Bermans were required to recognize under the installment method in a year equaled the proportion of the payments they received in that year that their gross profit on the sales of their stock to the ESOP bore to the total price to be received for the stock.

Reflections

Although the Bermans reported on their 2003 tax returns that they had acquired floating-rate notes equal to the gain they had realized from their sale of the ESOP stock (approximately $4.15 million), they later filed amended petitions to state that they did not in fact acquire ownership of all of the floating-rate notes reported on the return. The court’s decision therefore applied only to the approximately $2.08 million in floating-rate notes for which ownership and disposition were not disputed. The fate of the disputed notes remains unclear from the record, but presumably, if the Bermans are found to have owned those notes, the Tax Court would require the same result on the tax issue.

Berman, 163 T.C. No. 1 (2024)