We recently discussed the requirements for an IRC Section 1042 Tax Deferred Sale of Stock to an ESOP. One of the 4 requirements to qualify for Section 1042 sale, as provided under IRC Section 1042(b) - Sales of stock to employee stock ownership plans or certain cooperative – Requirements to qualify for nonrecognition, is to provide a written statement:

(3) Written statement required

(A) In general

The taxpayer files with the Secretary the written statement described in subparagraph (B).

(B) Statement

A statement is described in this subparagraph if it is a verified written statement of—

(i) the employer whose employees are covered by the plan described in paragraph (1), or

(ii) any authorized officer of the cooperative described in paragraph (l), consenting to the application of sections 4978 and 4979A with respect to such employer or cooperative.

How important is the written statement? Sometimes the Magic Words Really Matter describes a 2004 United States Tax Court ruling that found that a taxpayer was unable to exclude the gain on the sale of stock to an ESOP because the written statement requirement was not satisfied:

Mr. Clause wanted to take advantage of Section 1042 of the Internal Revenue Code. Section 1042 allows taxpayers who sell shares of a C corporation to the company Employee Stock Ownership Plan (ESOP) to avoid current tax on their gain if they reinvest the proceeds in publicly-traded securities, if certain other requirements are met. One of the requirements is an election under Section 1042 on a timely-filed tax return.

Mr. Clause did his part, reinvesting the proceeds. His CPA prepared his return excluding the gain. Unfortunately, the tax returns failed to include an election required under the Section 1042 regulations. The taxpayer failed to convince the Tax Court that "substantial" compliance had been achieved. The judge says:

"Having not literally complied with the election requirements in the statute and the regulation, petitioner argues that he substantially complied with the requirements of section 1042 and should, therefore, receive the benefits of the section because the failure to file the elections was 'purely administrative in nature'. We disagree."

The moral? It's best not to count on the kindness of tax administrators; better to say the magic words demanded by the rules when you file your returns, even if they seem silly. Mr. Clause's heirs will now presumably discuss the additional $395,279 tax on the failed ESOP rollover with the hapless CPA who prepared the return for the rollover year.

Substantial Compliance No Substitute for Filing Election discusses the details of the case and some observations:

Evidence of intent is an essential requirement to overcome a failure to file an election. Taxpayers can argue substantial compliance when they have provided most of the information required by the statute or regulations and the omitted information is not significant. Omitting income that otherwise would be excluded under a duly filed election from a tax return is not sufficient evidence of intent. The defense of substantial compliance generally will be unsuccessful in instances where the essential requirements of making the election clearly appear in the governing statute or regulations.