Pizza Pro v. Commissioner – Where Do We Go From Here?

By James E. Holland • February 14, 2017 • 0 Comments

On Nov. 17, 2016, the U.S. Tax Court issued its opinion in the case Pizza Pro Equipment Leasing, Inc. v. Commissioner of Internal Revenue (147 T.C. No. 14). The case (and a subsequent action by the IRS) has implications for taxpayers and practitioners with respect to amounts contributed to a defined benefit plan and elections under § 4972(c)(7). This article will review the major holdings in the case and the implications for providing advice.

There is a saying that bad cases make bad law (or, as sometimes stated, bad facts make bad law). Arguably, this is what happened in Pizza Pro Equipment Leasing, Inc. v. Commissioner of Internal Revenue (147 T.C. No. 14) (“Pizza Pro”). In that case, a unique (or absurd), but clearly aggressive, interpretation of how the IRC § 415 dollar limit is reduced for ages below age 62 resulted in a Tax Court opinion that considered the application of the excise tax provisions on nondeductible contributions under § 4972. The Tax Court’s opinion with respect to the excise taxes has implications for advice provided by practitioners to their clients.

Facts (Per Tax Court)

Pizza Pro Equipment Leasing, Inc. is located in Arkansas. The company adopted a defined benefit plan effective Jan. 1, 1995. At all times, the plan had just one participant, the company’s president. The normal retirement age was set at age 45. The normal retirement benefit was 100% of the participant’s average annual compensation payable in the form of a straight life annuity. The plan provided that the participant’s accrued benefits fully vested at death and were payable as a death benefit to the participant’s designated beneficiary. The company did not fund a defined contribution plan during any of the years involved in the case.

The plan year was always the calendar year. The valuation date was the last day of the plan year. Forms 5500 were filed for the plan for the plan years 2002-2006. Forms 5330 were not filed for any year. The plan’s enrolled actuary (who was not named in the opinion[1]) reviewed and approved the valuation work papers and signed the Schedules B to the Forms 5500 for the years involved.

For the years at issue, the plan was a prototype plan sponsored by a law firm with attorney Barry Jewell. For 2003-2006, the prototype plan was the Jewell Law Firm, P.A., Prototype Defined Benefit Plan & Trust Basic Plan Document. The adoption agreement stated that “this plan is proprietary to and a trade secret of Jewell Law Firm, P.A. and may not be used for more than sixty (60) days after the Employer’s relationship with Jewell Law Firm, P.A., has terminated.”

In determining the normal retirement benefit, the company reduced the § 415 dollar limit by applying a factor of (1/1.05)17 to reduce the limit from age 62 to age 45. The result of this calculation was used to determine the minimum funding requirements and the maximum deductible contributions. The company claimed the following for deductions to the plan:

Year

Contribution Deducted

2002

$292,470

2003

$263,817

2004

$283,406

2005

$225,352

2006

$1,704


IRS Audit and Disallowance

The IRS audited the plan and took issue with the amounts deducted. The IRS did not agree with the method used to reduce the § 415 dollar limit. In the view of the IRS the proper method was to (1) determine the present value of the dollar limit at age 62 by multiplying by an annuity purchase rate (APR) at age 62, using 5% interest and the mortality table in Rev. Rul. 2001-62 to determine the APR,[2] (2) discounting the result in (1) for interest only for 17 years (using the factor of (1/1.05)17 from above), and (3) convert to a single life annuity at age 45 by dividing by an APR for age 45, again using 5% interest and the mortality table in Rev. Rul. 2001-62 to determine the APR. The IRS determined a smaller § 415 dollar limit at age 45. From the opinion the comparative amounts (as stipulated) were:

Year

§ 415 Dollar Limit at Age 62

Taxpayer/Plan Limit at Age 45

IRS Limit at Age 45

2002

$160,000

$69,740

$52,935

2003

$160,000

$69,687

$53,150

2004

$165,000

$71,633

$54,811

2005

$170,000

$74,170

$56,472

2006

$175,000

$76,352

$58,133

 

Using the amounts from the table, the IRS re-determined the deductible amount and disallowed the excess contributions. The amounts allowed and disallowed (excess contributions) were:

Year

Original Contribution

Allowable Amount

Excess

2002

$292,470

$191,659

$100,811

2003

$263,817

$170,620

$93,197

2004

$283,406

$212,433

$70,973

2005

$225,352

$237,641

($12,289)

2006

$1,704

$15,451

($13,747)

 

The IRS then applied the 10% excise tax under § 4972 on nondeductible contributions, and taking into account the carryover of excess contributions. The calculations as in the following table:

(1)

Year

(2)

Excess Contributions

(3)

Prior Year Carryover

(4)

Total

[ (2) + (3) ]

(5)

§ 4972 tax

[10% of (4) ]

2002

$100,811

0

$100,811

$10,081

2003

$93,197

$100,811

$194,008

$19,401

2004

$70,973

$194,008

$264,981

$26,498

2005

($12,289)

$264,981

$252,692

$25,269

2006

($13,747)

$252,692

$238,945

$23,894

 

In addition to the 10% excise tax, the IRS applied penalties and interest. The penalties were for both failure to file the return and failure to pay the excise taxes.

In 2008, the IRS disallowed deductions for 2004 and 2005 and issued a notice of deficiency for the income taxes. The company filed a petition with the Tax Court to challenge the notices, but then agreed with the income tax deficiencies and a stipulated decision was entered on March 3, 2010.[3]

In October 2012, the IRS prepared substitute Forms 5330 for the years 2002 and 2003. Similarly, in February 2013, the IRS prepared substitute Forms 5330 for the years 2004, 2005, and 2006. The substitute returns showed the taxes dues as indicated above. In March 2015, the IRS issued notices of deficiency for the excise taxes on account of nondeductible contributions. Subsequently, the company filed a petition with the Tax Court challenging the excise tax deficiencies.

Issues Addressed by the Tax Court

In its opinion, the following issues were addressed by the court:

  • Was the correct method to reduce § 415(b) dollar limit for retirement age before age 62 used by taxpayer/plan?
  • Whether § 4972 excise taxes applied for 2002-2006 because contributions were made in excess of § 404 limitations?
  • Whether a valid election was made under § 4972(c)(7)?
  • Whether additions to tax under §§ 6651(a)(1) and (2) apply?
  • Whether the statute of limitations applied to bar assessment and collection of the § 4972 excise taxes?

Of the issues, the ones of greatest importance to practitioners are those relating to section 4972. In particular, the opinion with respect to the third issue has ongoing implications for practitioners.

Section 415 Dollar Limit Reduction

The years involved in the case were prior to the effective date of the current regulations under § 415. The court opined that the relevant regulations were those that existed for the years when the tax deficiency arose, which were the prior § 415 regulations. The issue thus became, under the prior regulations, what was the proper methodology to reduce the dollar limitation from age 62 to age 45. This mattered because, under § 404(j)(1)(A), in computing the amount of an allowable deduction “in the case of a defined benefit plan, there shall not be taken into account any benefits for any year in excess of any limitation on such benefits under section 415 for such year.” (Quote in court’s opinion; see bottom of page 22 and top of page 23.)

After reviewing the relevant law, regulations, and IRS guidance that had been issued, the court focused on the requirement of § 1.415-3(e) of the prior regulations that the where a retirement benefit under a defined benefit plan begins before age 55,[4] “the plan benefit is the adjusted to the actuarial equivalent of a benefit beginning at age 55 in accordance with rules determined by the Commissioner.” While notices issued by the IRS under the prior regulations had stated the mortality decrement was ignored to the extent that a forfeiture does not occur upon death, the court did not believe they were sufficiently clear on the appropriate methodology to be dispositive. Recognizing that actuarial equivalence is “an elusive concept not defined in the Code,” and after citing some case law under ERISA, the court turned to expert testimony.

The expert for the company was a mathematician who was not an actuary. The expert for the IRS was an actuary employed by the IRS who was both an FSA and an enrolled actuary, and who spent 28 years in the private sector prior to joining the IRS. In short, the court agreed with the expert from the IRS and his criticisms of the mathematician’s report. The court also took note that the methodology was consistent with the current regulations and the examples therein. Accordingly, the court agreed with the methodology used by the IRS to reduce the dollar limit.[5]

If the proper methodology for reducing the § 415 dollar limit was the only issue, most practitioners would be glad that the court validated what they had understood and been doing all along. However, the court then turned to the application of § 4972.

§ 4972 Taxes

The IRS applied the § 4972 excise taxes as set forth above. The court started its discussion with the statutory background. The opinion stated that § 4972(a) imposes a tax of 10% on an employer’s nondeductible contributions to a qualified employer plan. After reciting the definition of nondeductible contributions in§ 4972(c)(1) and the ordering rule in § 4972(c)(2), the court focused on the exception for defined benefit plans under § 4972(c)(7).

For years beginning before 2007, § 4972(c)(7) stated: “In determining the amount of nondeductible contributions for any taxable year, an employer may elect for such year not to take into account any contributions to a defined benefit plan except to the extent that such contributions exceed the full-funding limitation (as defined in section 412(c)(7), determined without regard to subparagraph (A)(I)(1) thereof).” After the years at issue in the case, the court stated “the full-funding limitation threshold was limited to multiemployer plans only; following this amendment, employers effectively could elect to treat all their contributions to single-employer plans as deductible.”[6] (emphasis added) Thus, it appears that in setting forth the statutory requirements, the court made a statement about the impact of an election under § 4972(c)(7) for years after the amendments made by the Pension Protection Act of 2006 (PPA).

In focusing on the company’s excise tax liabilities, the court noted that the impact of the lower § 415 limitations was a lower minimum funding requirement and lower deductible contributions.[7] Aside from the recalculation of the § 415 limits, there was no challenge to the accuracy of the calculations of the excess contributions and corresponding excise tax amounts. The court therefore stated: “Accordingly, unless petitioner can demonstrate the applicability of an exception to the excise tax, such as under section 4972(c)(7), we must hold petitioner liable for the tax.”[8] The focus shifted to the application of § 4972(c)(7).

Application of § 4972(c)(7) Exception

The court observed that “neither the statute nor the regulations provide any guidance on how to make the election under section 4972(c)(7).” The company contended that, in the absence of any guidance, not filing an excise tax return on Form 5330 should be considered tantamount to making the election. The court was not sympathetic to this argument, and pointed out a flaw with respect to the case law relied upon.

The court noted that there is no clear precedent for what constitutes a valid election where the Code calls for an election but there is no regulation or guidance specifying how it is to be made, and that the question had been approached case by case. In some cases, an affirmative election was required. In other cases, no formal election was required. The court stated in what I believe is the key paragraph:

“In this case, what we find particularly troublesome with petitioner’s assertion that its not filing a Form 5330 is tantamount to making a section 4972(c)(7) election is that it is untimely and self-serving. A taxpayer cannot claim sufficient intent to make the election without something more concrete to evince such intent than its pinky-promise well after the fact that it really did intend to make it. Petitioner’s retroactive assertion of an intended election is especially unconvincing in view of petitioner’s agreement to pay the income tax deficiencies arising out of respondent’s disallowance of a portion of petitioner’s claimed deductions for contributions to the plan in tax years 2004 and 2005. This Court entered stipulated decisions on March 3, 2010, to that effect in docket Nos. 7124-08 and 29393-08. Notwithstanding the six years that have passed since that time, petitioner to date has not filed any Forms 5330 for those years nor for any of the others at issue in this case. Had petitioner done so timely, it would have been able to evidence its section 4972(c)(7) election by completing the appropriate line on the Form 5330.13 Petitioner did none of the above and instead claims in its opening brief that “the settlement of the Tax Court cases was intended as a temporary step and not a concession.” This Court is hardly a waystation for taxpayers waiting for Godot: Our decisions, if not appealed, are final. See sec. 7481(a)(1).”[9]

Footnote 13 in the opinion is an important part of the above paragraph. That footnote reads:

The line is for “Nondeductible section 4972(c)(6) or (7) contributions exempt from excise tax”. This line is 13j in Part II of the November 2002 and October 2003 revisions of Form 5330; line 14j in Part II of the August 2004 and March 2007 revisions; and line 10 in Schedule A of the January 2008 and subsequent revisions. Indicating a value in this line of the excise tax return necessarily presupposes that the taxpayer made the election. A taxpayer may also evidence its election by submitting a protective election with the Form 5500 filed on behalf of its pension plan. (emphasis added)

The court then stated, “In light of the above, we find that petitioner has failed to make a valid election for any of the tax years 2002 through 2006 under section 4972(c)(7) to disregard certain nondeductible contributions.”[10] In essence, not liking the behavior of the company, the court held against the idea of not filing a Form 5330 to be tantamount to an election under § 4972(c)(7). Thus, one can say “bad facts make bad law.” Better behavior might have given rise to a different result.

IRS Reaction and Going Forward

In early 2016, the IRS had posted on its website instructions to agents concerning the election under § 4972(c)(7). Those instructions stated that a taxpayer should be deemed to have made the election. Subsequently, after the Pizza Pro decision, the instructions have been taken down. Plainly, at a minimum, the IRS is rethinking its view.

All is not lost, however. The court provided a clear (and relatively easy) path in footnote 13. The italicized statement signals that an attachment making an election to Form 5500 would be accepted as a timely election. While filing a Form 5330 to show no tax may be acceptable, it carries a risk of attracting unwanted attention. Even a “compliance check” from the IRS can be upsetting to a taxpayer. Prudence suggests that an attachment with the Form 5500 or 5500-EZ would be better. Another idea is to have a contemporaneous signed election in the file, but note that was not explicitly blessed by the court.

Remaining Issues

After addressing the application of § 4972(c)(7), the court went on to find that the penalties on failure to file a return and failure to pay the tax, §§ 6651(a)(1) and (2), respectively applied. In doing so, it once again held that there was no reasonable cause for the failures and that reliance on the promoter of the plan was not acceptable.

Finally, the court addressed the statute of limitations. The court held that the failure to file Forms 5330 meant that the statute of limitations had not begun to run. In doing so, the court rejected the idea that the filing of Form 5500 should start the statute of limitations.[11] The court’s view (which agreed with that of the IRS) was consistent with Revenue Ruling 2003-88, which held that the statute of limitations for § 4971 did not start to run until the Form 5330 was filed.

Some may advocate that a Form 5330 with no tax showing should be filed for every year in order to start the statute of limitations. That seems unnecessary for § 4972 purposes because it is easier to attach an election to the Form 5500. Of course, filing a Form 5330 has the problems of attracting unwanted attention as mentioned above.

Conclusion

A case that started out as a technical § 415 issue ended up with a precedent setting holding regarding elections under § 4972(c)(7). [12] Almost all actuaries have no problem with the result under § 415. The result under § 4972(c)(7) requires some thinking about changing the advice provided.

Given the statements by the court concerning the result of an election, the rejection of a deemed election by non-filing a Form 5330, and the clear signal of what is acceptable, it appears that taxpayers are better served by routinely making an attachment to any Form 5500 filing stating that the election has been made under § 4972(c)(7). That means that practitioners will need to recommend making (and preparing, etc.) such an attachment until such time as the law changes or the IRS provides reliable guidance otherwise.

As a final thought, the theme that “bad cases make bad law” should be remembered. In tough situations, we can help avoid bad law by acting in a reasonable matter. Sometimes that may mean providing advice that clients may not want to hear. Of course, that is easier to say than to do, but we may be better served in the long run.

Footnotes

[1] My understanding from a practitioner closer to the case is that the actuary is deceased.

[2] Remember that for the years involved the table in Revenue Ruling 2001-62 was the applicable mortality table under § 417(e)(3).

[3] The opinion was not clear as to whether the IRS disallowed deductions for the years 2002 and 2003, however, I have been informed that income tax adjustments were proposed for those years as well.

[4] Footnote 6 in the opinion noted that the law had been changed so that age 62 was the relevant age by the years at issue.

[5] For those who want to read through the reasoning see pages 22-39 of the court’s opinion.

[6] See the bottom of page 40 of the opinion.

[7] The expert for the IRS stated, in his report, that the minimum funding standard was the applicable deduction limit for the years under examination. See footnote 11 in the opinion.

[8] Last sentence on page 43.

[9] See paragraph starting on page 46 and ending on the top of page 47.

[10] Paragraph at bottom of page 47.

[11] The full reasoning and analysis can be found on pages 54 through 57 of the opinion.

[12] Because the opinion is a Tax Court opinion, it is precedent setting for the Tax Court.

 

RETURN TO THE ACOPA MONTHLY HOME PAGE