USCA1 Opinion
March 30, 1993
[NOT FOR PUBLICATION]
UNITED STATES COURT OF APPEALS
FOR THE FIRST CIRCUIT
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No. 92-1938
PETER A. JOHNSON AND CLAIRE P. LYON,
Petitioners, Appellants,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent, Appellee.
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APPEAL FROM THE UNITED STATES TAX COURT
[Hon. Theodore Tannenwald, U.S. Tax Court Judge]
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Before
Selya, Cyr and Boudin,
Circuit Judges.
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Peter A. Johnson and Claire P. Lyon on brief pro se.
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James A. Bruton, Acting Assistant Attorney General, Gary R.
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Allen, Jonathan S. Cohen and Regina S. Moriarty, Attorneys, Tax
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Division, on brief for appellee.
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P. Lyon, appeal a decision of the Tax Court that sustained a
Per Curiam. The appellants, Peter A. Johnson and Claire
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Tax Court's decision.
appellants' joint income tax return for 1986. We affirm the
deficiency determined by the Internal Revenue Service on the
I
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shareholders of liquidating corporations. Under 26 U.S.C.
Hampshire. Mr. Johnson is a certified public accountant and
regulation. In 1980, Mr. Johnson and Ms. Lyon incorporated
primarily to law firms practicing in the field of energy
Peter A. Johnson Associates, Inc. (PAJA), through which Mr.
for a number of years made his living as a consultant,
corporation initially issued 100 shares of stock: 51 shares
Johnson then carried on his consulting business. The
Mr. Johnson and Ms. Lyon are married and reside in New
to Mr. Johnson and 49 shares to Ms. Lyon. The corporation
Trust.
consulting work tapered off. Late in 1986, with PAJA
he accepted a salaried position at a hospital and his
relatively dormant, Mr. Johnson and Ms. Lyon decided to
Mr. Johnson worked full-time for PAJA until 1985, when
shareholders.
liquidate the company and distribute its assets to the
later sold 8 more shares to an entity known as PAJA Pension
At the time, the tax laws offered a choice to
331, they could recognize all of the distributed assets on
their income tax returns for the year in which the
liquidation occurred, but pay taxes on the distribution at
the capital gains rate, which was lower than the rate applied
to "ordinary income" such as wages or dividends. Or, they
could elect to treat the distribution under 26 U.S.C. 333.
Section 333 required the shareholders to allocate the
distributed assets to two categories: (1) earnings and
profits, and (2) all other assets. The shareholders had to
declare the portion of the distribution that came from
earnings and profits as ordinary income on their returns for
the year in which the liquidation occurred, and pay taxes on
it at the higher income tax rate. However, with respect to
the portion of the distribution that took the form of the
corporation's other assets, the shareholders could postpone
recognizing any gain until they themselves sold the assets.
Roughly speaking, then, Section 333 was a good deal only for
shareholders of "a corporation holding appreciated property
but having little or no earnings and profits . . . ." B.
Bittker & J. Eustice, Federal Income Taxation of Corporations
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and Shareholders at 11.62 (5th ed. 1987). If the
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corporation had significant earnings and profits, the
shareholders were better off electing Section 331,
recognizing a gain immediately on the entire distribution,
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but avoiding taxation of the earnings and profits at the
higher income tax rates.
This case concerns the appellants' election to treat
PAJA's distributed assets under Section 333 when they
dissolved the corporation at the end of 1986. Mr. Johnson
knew that Congress had repealed Section 333, effective
January 1, 1987. See Pub.L. 99-514, Title VI, 631(e)(3),
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Oct. 22, 1986, 100 Stat. 2273. He thus felt some urgency to
liquidate PAJA by year's end. But, because personal business
intervened, he did not sit down to the task until December
28, 1986.
Mr. Johnson and Ms. Lyon executed a number of documents
on December 28. The first was a Form 1120-A, a "Short-Form
Corporation Income Tax Return" for PAJA. This document
showed that PAJA had assets of $132,249, of which "retained
earnings" constituted $96,311. With such a significant
amount of earnings -- which the shareholders would have to
declare as ordinary income under Section 333, but could treat
as a capital gain under Section 331 -- liquidation under
Section 333 was an unwise choice.
However, the appellants made it. For reasons never
fully explained, Mr. Johnson figured PAJA's "earnings and
profits" at zero when deciding whether to elect Section 331
or Section 333. Consequently, he and Ms. Lyon made a written
shareholder resolution to liquidate the corporation under
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Section 333. Each of them executed and filed with the IRS a
Form 964, which bears the caption "Election of Shareholder
under Section 333 Liquidation." Mr. Johnson also executed
and filed, on behalf of the corporation, a Form 966,
captioned "Corporate Dissolution or Liquidation," which
identified Section 333 as the "Section of the Code under
which the corporation is to be dissolved or liquidated."
Mr. Johnson then wrote checks on PAJA's corporate account
that distributed more than $137,000 in assets: $64,607 to
himself, $63,632 to Ms. Lyon, and $9,622 to PAJA Pension
Trust.
Four months later, when Mr. Johnson and Ms. Lyon filed
their joint income tax return for 1986, they should have
attached copies of the already-filed Forms 964, to alert the
IRS to their election, see 26 C.F.R. 1.333-3 and 1.333-
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6(a)(5), and treated their share of the distributed assets
pursuant to Section 333 -- that is, by declaring the portion
attributable to earnings and profits as ordinary income, but
postponing recognition of any gain on the remainder.
The appellants did not do what their election required
them to do. They did not attach Form 964; in fact, their
income tax return contained no mention of the liquidation.
It characterized all of the money they had received from the
liquidation as proceeds of a "sale" of PAJA stock, and
treated the entire distribution as a capital gain. This
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calculation would have been consistent with a liquidation
under Section 331, or with a simple sale of stock
unaccompanied by a liquidation, but it did not jibe with the
Section 333 election the appellants had made the previous
December.
The IRS accepted the appellants' return and took no
further action until an audit in 1988 revealed the
inconsistency between the election under Section 333 and the
tax treatment given the distribution in the appellants'
return. The IRS then rejected the appellants' efforts to
revoke their Section 333 election, recalculated their tax
liability to take the election into account, determined a
deficiency of $24,790, and added penalties for negligence and
for making a substantial understatement of taxes owed. The
appellants sought review in the Tax Court, which held a one-
day trial and sustained the IRS' actions. This appeal
followed.
II
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Mr. Johnson and Ms. Lyon say that they are not liable
for taxes calculated according to Section 333 for two
reasons: first, because they never made a valid election; and
second, because their election, even if formally valid, was
based on a mistake and was therefore revocable.
A
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The appellants point to a number of errors they say they
made while attempting to elect Section 333 and liquidate
PAJA, and assert that strict compliance with all of Section
333's requirements is necessary in order to enjoy the
benefits (or in this case, suffer the detriments) of the
statute. This is not completely true. The level of
compliance needed to make a valid tax election varies
according to the nature of the requirement. The IRS "'may
insist upon full compliance with [its] regulations' when the
regulatory requirements relate to the substance or essence of
a statute, but [the Tax Court has] held that substantial
compliance with regulatory requirements may suffice when such
requirements are procedural and when the essential statutory
purposes have been fulfilled." American Air Filter Co. v.
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Commissioner, 81 T.C. 709, 719 (1983) (citations omitted).
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See also Dunavant v. Commissioner, 63 T.C. 316 (1974) (same,
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construing Section 333).
Two of the regulations which the appellants say they
violated -- 26 C.F.R. 1.333-6, which required them to
provide supplemental information about the liquidation, and
26 C.F.R. 1.333-3, which required them to file a copy of
Form 964 along with the original at the time of election --
plainly do not go to the "essence" of the statute and are
therefore "procedural" in the sense discussed above. Their
breach will not defeat the election.
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The other asserted defects require some discussion.
First, the appellants say that the distribution was not "in
complete cancellation or redemption of all the stock," 26
U.S.C. 333(a)(1), because their Forms 964 inaccurately
listed the number of shares each held. Mr. Johnson owned 51
shares at the time of the election, but listed only 47 in his
Form 964; Ms. Lyon owned 49 shares, but listed only 46.
The premise does not support the conclusion. Nothing in
the record causes us to believe that, in return for the
company's assets, Mr. Johnson and Ms. Lyon (and PAJA Pension
Trust) actually gave up anything less than all of their
shares in PAJA. And if that is so, then the distribution was
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"in complete cancellation or redemption of all the stock."
Putting the wrong count on the forms did not affect the
substance of the liquidation and therefore did not go to the
essence of the statute.
Second, the appellants claim that they failed to make a
timely election. Section 333(d) says: "The filing [of the
written election form] must be within 30 days after the date
of the adoption of the plan of liquidation." The cases
indicate that this is an "essential" requirement. Shull v.
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Commissioner, 291 F.2d 680, 682-85 (4th Cir. 1961); Kelley v.
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Commissioner, 10 T.C.M. 143, 146 (1951). However, whether
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and when a plan of liquidation was adopted "is a question of
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fact ordinarily for the Tax Court," Shull, 291 F.2d at 684,
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and thus subject to review only for clear error.
We see no error in the Tax Court's finding that "the
evidence clearly establishes December 28, 1986 [when the
appellants executed a written shareholder resolution], as the
date of the adoption of the plan of liquidation." It is true
that Mr. Johnson testified that he and Ms. Lyon made a
"decision" to liquidate PAJA sometime in November 1986. It
is also true that Section 333 does not require "that a plan
of liquidation must be in writing or in any particular form."
Shull, 291 F.2d at 682.
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But the statute does by its terms require the
shareholders to "adopt" some "plan" of liquidation. In
Shull, the Fourth Circuit held that the shareholders had
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"adopted" a plan of liquidation before they made a formal
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resolution to that effect only because the shareholders had
previously "acted deliberately . . . and had gone so far in
the actual execution of a plan of liquidation as to dissolve
the corporation and terminate its existence for all purposes
other than liquidation. . . ." 291 F.2d at 684-85. Nothing
of this sort happened here. The resolution executed on
December 28 was the first manifestation of the appellants'
intention to dissolve PAJA. In the absence of any evidence
to corroborate Mr. Johnson's testimony, the Tax Court was
entitled to find either that the "decision" in November never
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happened, or that it happened but was too indefinite an event
to trigger the statutory filing requirement, and to conclude
that the appellants did not "adopt" a plan of liquidation
within the meaning of Section 333(d) until December 28 -- the
same day that they made the election and filed Form 964.
Third, the appellants contend that PAJA failed to
distribute all of its assets before the end of December 1986,
thus violating Section 333(a)(2), which says that the
benefits of election are available only if "the transfer of
all the property under liquidation occurs within some one
calendar month." Since the bulk of the distribution occurred
in December 1986, when Mr. Johnson wrote corporate checks to
himself, his wife and PAJA Pension Trust, the entire
transaction had to be completed during that same "one
calendar month." But, the appellants say, the distribution
was not completed until March 1987, when Spriggs, Bode &
Hollingsworth (one of PAJA's law firm clients) made a payment
of $6,727 for "services rendered during November 1, 1986
through March 10, 1987."
We agree with the Tax Court that only some
"indeterminate" portion of this payment -- the part
attributable to services rendered before PAJA was dissolved
at the end of December 1986, and thus "earned" by the company
-- can be considered a "distribution" from PAJA to its
shareholders. Any money paid for services rendered after the
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dissolution was money that Mr. Johnson earned on his own
behalf.1
The late distribution of such a relatively small amount
-- something less than $6,727 and thus less than 5% of the
PAJA's assets -- does not affect the legitimacy of the
election. A "liberality of approach" exists with respect to
tax statutes that require corporate liquidations to be
accomplished within specific time limits. Cherry-Burrell
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Corp. v. United States, 367 F.2d 669, 677 (8th Cir. 1966)
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(Blackmun, J.). Thus, when a tax statute on its face
requires distribution of all corporate assets within a
certain period in order to qualify for a tax benefit, the
failure to dispose of a minor portion of the assets within
the time allotted will not defeat the taxpayer's choice. See
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Mountain Water Co. v. Commissioner, 35 T.C. 418 (1960)
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(calling this the "de minimis rule"); Estate of Lewis B.
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Meyer v. Commissioner, 15 T.C. 850 (1950), rev'd on other
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grounds 200 F.2d 592 (5th Cir. 1952) (it "would be out of
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line with [the predecessor to Section 333] . . . to hold that
the failure, within the calendar month, physically to deliver
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1. For the same reason, a check received from a second
client in March 1987 was not part of the distribution of
corporate assets because it represented payment of Mr.
Johnson's monthly retainer for January, February, and March
1987 -- i.e., money earned after the dissolution by Mr.
Johnson, not by the corporation.
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less than 6 percent in book value of the distributed assets
destroys the election. . . ").
Finally, the appellants would have us rule that, because
they reincorporated PAJA in 1991, they are not bound by the
election they made more than four years earlier. They supply
no useful authority for this proposition. The cases and
revenue rulings they cite are inapposite; all involved the
question whether a complete liquidation had occurred in the
first place. See, e.g., Telephone Answering Service Co. v.
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Commissioner, 63 T.C. 423 (1974). In this case, the record
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shows that the appellants distributed PAJA's assets in the
successful pursuit of a complete and permanent liquidation.
Their belated revival of the corporate form, done after the
IRS had determined a tax deficiency (and for no apparent
reason other than to escape the consequences of that
determination), "did not alter the character" of the previous
distribution or affect the validity of their election. See
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Kennemer v. Commissioner, 96 F.2d 177, 178-89 (5th Cir.
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1938).
B
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Even if their election was procedurally valid, the
appellants say, the IRS should have allowed them to revoke it
because it was based on the mistaken belief that PAJA had no
"earnings and profits" to distribute to its shareholders.
Although (with one exception not relevant here) the
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regulations implementing Section 333 say flatly that a
written election to be governed by that provision "cannot be
withdrawn or revoked," 26 C.F.R. 1.333-2(b)(1), the
appellants believe that a taxpayer may nevertheless obtain
relief from an election made as the result of a mistake.
The courts have on occasion allowed taxpayers to revoke
mistaken elections. See, e.g., Meyer's Estate v.
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Commissioner, 200 F.2d 592 (5th Cir. 1952); McIntosh v.
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Wilkinson, 36 F.2d 807 (E.D.Wis. 1929); DiAndrea, Inc. v.
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Commissioner, 47 T.C.M. 731 (1983) (revoking election under
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Section 333). However, in each of these cases the taxpayer
made what the court characterized as a "mistake of fact." In
deciding whether to allow taxpayers to revoke otherwise-valid
elections, the courts have consistently distinguished between
mistakes of fact, which may justify revocation, and mistakes
of law, which will not. See Bankers & Farmers Life Ins. Co.
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v. United States, 643 F.2d 234, 238 (5th Cir. 1981); Shull v.
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Commissioner, 271 F.2d 447, 449 (4th Cir. 1959); Raymond v.
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United States, 269 F.2d 181, 183 (6th Cir. 1959); Grynberg v.
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Commissioner, 83 T.C. 255, 261-63 (1984); Cohen v.
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Commissioner, 63 T.C. 527 (1975). "Oversight, poor judgment,
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ignorance of the law, misunderstanding of the law,
unawareness of the tax consequences of making an election,
miscalculation, and unexpected subsequent events have all
been held insufficient to mitigate the binding effect of
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elections made under a variety of provisions of the [Internal
Revenue] Code." Estate of Stamos v. Commissioner, 55 T.C.
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468, 474 (1970) and cases cited therein.
The appellants do not question the wisdom of this
distinction, but argue that the Tax Court erroneously
described their mistake as one of law. We agree with the Tax
Court. The mistake in this case was Mr. Johnson's stated
belief that PAJA had no "earnings and profits," and thus that
the shareholders could defer recognition of the entire
distribution under Section 333. Depending on its source,
this could have been a mistake of fact or a mistake of law.
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"[M]istakes of fact occur in instances where either (1) the
facts exist, but are unknown, or (2) the facts do not exist
as they are believed to." Hambro Automotive Corp. v. United
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States, 603 F.2d 850, 855 (C.C.P.A. 1979). If Mr. Johnson had
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decided that PAJA had no "earnings and profits" because he
believed it had no money in the bank, then his mistake would
have been a mistake of fact. But, as the Tax Court found, it
is "difficult to believe" that the appellants were unaware of
PAJA's cash reserves when they made the election on December
28, 1986, for on the same day, Mr. Johnson, as president of
PAJA, executed a corporate tax return indicating that the
company had more than $96,000 in "retained earnings," and
wrote checks to himself, Ms. Lyon and PAJA Pension Trust,
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drawn on the corporate bank account, totaling more than
$137,000.
Since the appellants knew how much money the corporation
had in the bank when they made the election, the only
plausible explanation for their mistake is that they did not
know that the money constituted "earnings and profits"
subject to taxation as ordinary income under Section 333.
See GPD, Inc. v. Commissioner, 508 F.2d 1076, 1082 (6th Cir.
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1974) (corporation's "earnings and profits" may not bear an
"exact relation" to earnings as determined by "normal
corporate accounting methods"); Bennett v. United States, 427
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F.2d 1202, 1208 (Ct.Cl. 1970) ("'earnings and profits' . . .
is a tax, not an economic concept"). Thus, they made a
mistake of law, which occurs "where the facts are known, but
their legal consequences are not known or are believed to be
different than they really are," Hambro Automotive Corp. v.
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United States, 603 F.2d at 855 (emphasis omitted), and may
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not revoke their election.
III
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The IRS made two "additions" to the appellants' tax
liability. First, it added $1,240 under 26 U.S.C.
6653(a)(1), which says: "If any part of the underpayment . .
. of tax required to be shown on a return is due to
negligence (or disregard of rules or regulations), there
shall be added to the tax an amount equal to 5 percent of the
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underpayment." "Negligence in this context is a lack of due
care or failure to do what a reasonable and ordinarily
prudent person would do under the circumstances. The
Commissioner's imposition of a negligence addition is
presumptively correct, leaving the [appellants] with the
burden of proving that their underpayment was not due to
negligent or intentional rules violations." McMurray v.
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Commissioner, Nos. 92-1513 and 92-1628, slip op. at 13 (1st
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Cir. February 9, 1993). We review the Tax Court's findings
on negligence issues only for clear error. Leuhsler v.
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Commissioner, 963 F.2d 907, 910 (6th Cir. 1992).
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There was no error. The "underpayment" in this case
occurred because the appellants, having elected in December
1986 to treat their taxes under Section 333, instead prepared
their tax return the following April as if they had either
elected Section 331 or made a simple sale of stock
unaccompanied by a liquidation. Under the circumstances, and
absent a compelling explanation to the contrary, one might --
as the Tax Court appears to have done in its Supplemental
Memorandum Opinion -- infer that the "switch" here was
deliberate, since making it promised to save the appellants
some $24,000, and since the appellants obscured the de facto
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revocation of their previous election by describing the
distribution as a "sale" rather than a liquidation, and by
neglecting to attach Form 964 to their return. But the
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negligence penalty was appropriate even if the switch was
accidental; like the Tax Court, we see nothing reasonable
about a certified public accountant's failure to calculate
his tax liability in accordance with his own election and the
Code's explicit instructions.2
The IRS also added $6,198 under 26 U.S.C. 6661(a).
Section 6661(a) imposes a 25% addition to an underpayment if
"there is a substantial understatement of income tax for any
taxable year." Section 6661(b)(1)(A) defines a substantial
understatement as one that exceeds the greater of (1) 10% of
the tax for the year or (2) $10,000. Section 6661(b)(2)(B)
reduces the understatement by any amount attributable to (i)
the tax treatment of an item if there was "substantial
authority" for the treatment, or (ii) any item with respect
to which the relevant facts affecting its tax treatment are
adequately disclosed in the return or a statement attached to
it.
The appellants understated their taxes by more than
$24,000, which was almost 50% of the tax for the year.
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2. Ms. Lyon's reliance on her husband's expertise does not
excuse her negligence. Although Section 6653(b), which
authorizes an addition to tax for fraud, contains a "special
rule for joint returns" that allows the IRS to penalize a
spouse only to the extent that the underpayment is due to her
own fraud, 26 U.S.C. 6653(b)(3), Section 6653(a), which
authorizes the penalty for negligence, contains no such
qualification. See Langer v. Commissioner, 59 T.C.M. 740
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(1990) (sustaining negligence penalty against both spouses
where husband, an IRS agent, prepared the erroneous return).
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However, they claim to have satisfied the disclosure
requirement with respect to the entire understatement
because, when they made the election in December 1986, they
filed Forms 964 and 966 with the IRS. But this "disclosure"
was inadequate for two reasons. First, it was not made on
the return or on a statement attached to the return. 26
C.F.R. 1.6661-4(a) and (b). Second, filing a Form 964 at
the time of liquidation, nearly four months before a tax
return is due, is not an act that "reasonably may be expected
to apprise the Internal Revenue Service of the identity of
the item, its amount, and the nature of the potential
controversy concerning the item." 26 C.F.R. 1.6661-
4(b)(1)(iv) and 1.6661-4(b)(4). That is precisely why the
regulations require the shareholder to file Form 964 twice --
once upon making the election and again with his income tax
return. 26 C.F.R. 1.333-3 and 1.333-6(a)(5).
The IRS has the authority to waive all or part of a
Section 6661 addition to tax "on a showing by the taxpayer
that there was reasonable cause for the understatement . . .
and that the taxpayer acted in good faith." 26 U.S.C.
6661(c). The most important factor in waiver decisions is
"the extent of the taxpayer's effort to assess [his] proper
tax liability under the law . . . ." 26 C.F.R. 1.6661-
6(b).
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We review the IRS' waiver decision only for abuse of
discretion. Heasley v. Commissioner, 902 F.2d 380, 385 (5th
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Cir. 1990); Mailman v. Commissioner, 91 T.C. 1079, 1083-84
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(1988). For the reasons already stated, we are confident
that the IRS did not abuse its discretion by concluding that
reasonable people acting in good faith would not (a) fail to
pay the tax in accordance with their election, and (b) fail
to notify the IRS that they were, in effect, revoking that
election.
The appellants' Motion for Oral Argument is denied.
The judgment of the Tax Court is affirmed.
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