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SOMETIMES THE MAGIC WORDS REALLY MATTER

February 10, 2004

Congress and the IRS have become less nit-picky in recent years. It is now fairly easy to make late S corporation elections good, for example. It also used to be impossible to catch a break for taking more than 60 days to roll over an IRA withdrawal; now there are good cause exceptions.

Even so, there are still parts of the tax law where only the right words on a timely-filed form stand between the taxpayer and tax disaster. The Estate of John Clause learned that lesson the hard way in Tax Court yesterday.

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.

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