T.C. Memo. 1998-318

UNITED STATES TAX COURT

HOWARD E. CLENDENEN, INC., Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 18155-96R. Filed September 3, 1998. 

Paul F. Christoffers, for petitioner.

Lawrence H. Ackerman, for respondent.

MEMORANDUM OPINION

TANNENWALD, Judge: This is an action for a declaratory

judgment regarding the qualification of petitioner's employee

stock ownership plan and trust. On May 22, 1996, respondent

issued a final revocation letter to petitioner stating that the

Howard E. Clendenen, Inc. Employee Stock Ownership Plan (the
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1 Unless otherwise indicated, all section references are to

the Internal Revenue Code as in effect for the years in issue,

and all Rule references are to the Tax Court Rules of Practice

and Procedure.

ESOP) failed to meet the requirements of section 401(a)1 for the

plan years beginning after June 30, 1985, and that its related

trust (the trust) was not tax exempt under section 501(a) for

those years. 

The issue for decision is whether amounts contributed to the

trust and allocated to one of the ESOP's participants exceed the

limitations in section 415, thereby causing the trust not to

constitute a qualified trust under section 401(a).

Background

Petitioner is a corporation with its principal place of

business located in West Des Moines, Iowa, at the time of the

filing of the petition in this case. It filed its Federal tax

returns for the years in issue with the Internal Revenue Service

Center in Kansas City, Missouri. Petitioner utilizes the accrual

method of accounting with a fiscal year ending June 30 as its

taxable year. 

Petitioner was incorporated on July 15, 1983, and its

principal business activity is insurance consulting. It is the

employer and plan administrator with respect to the ESOP, a

defined contribution plan. It established the ESOP and the trust

on September 6, 1983, effective for plan years beginning on or
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after July 15, 1983, and amended the ESOP effective June 30,

1985, and July 1, 1989. Petitioner received favorable

determination letters with respect to the ESOP and trust dated

December 8, 1983, March 24, 1986, and March 22, 1990. The plan

year and limitation year of the ESOP and the trust are the fiscal

year ending June 30. 

The trust is and has been petitioner's sole shareholder

since petitioner's incorporation. Petitioner issued shares of

its stock to the trust in payment of the contributions to the

trust and in exchange for cash. 

Howard E. Clendenen (Mr. Clendenen) is and has been

petitioner's president. On June 28, 1986, petitioner's board of

directors resolved:

That Howard E. Clendenen has advised the Corporation

that he desires to forego [sic] one-half of his salary

and bonuses for the fiscal year ended June 30, 1986

with the understanding that said one-half of his salary

and bonuses shall be contributed to * * * [the trust]. 

It is further understood that this transaction shall be

considered an employee contribution. 

On June 29, 1987, petitioner's board passed a resolution

identical to that of June 28, 1986, resolution except for the

1987 year. 

The ESOP's records reflect the following contributions to

the trust allocated to petitioner's employees as shown: 
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Plan Employer Employee

Year Employee Contribution Contribution

1986 Howard E. Clendenen 0 $17,029.38

1987 Howard E. Clendenen $ 9,000.00 30,000.00

1988 Howard E. Clendenen 0 0

1989 Howard E. Clendenen 11,250.00 0

Paul Clendenen 1,949.82 0 

 1989 total 13,199.82 0

1990 Howard E. Clendenen 9,000.00 0

Paul Clendenen 3,299.88 0 

1990 total 12,299.88 0

1991 Howard E. Clendenen 8,250.00 0

Paul Clendenen 3,975.00 0 

1991 total 12,225.00 0

These contributions were reflected in the trust's Forms

5500-C Return/Report of Employee Benefit Plan for each of such

years. 

Petitioner reported the following expenditures on its U.S.

Corporation Income Tax Returns: 

Year

Total

Compensation of

Officers

Salaries

and Wages

Pension,

profitsharing,

etc., plans

1986 $34,058.76 0 n/a

1987 36,697.01 0 $9,000.00

1988 0 0 0

1989 0 $12,998.80 13,199.82

1990 0 21,999.20 12,299.88

1991 0 26,500.00 12,225.00
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2 Mr. Clendenen was divorced on Jan. 11, 1988.

In addition, petitioner reported the following expenses under

"Other Deductions": 

Year Item Amount 

1987 Sec. 401(k) bonuses $30,000.00

1989 Commission expenses 75,000.00

1990 Bonuses 60,000.00

1991 Commissions 41,660.28

Bonuses 55,000.00

For the calendar years 1986 and 1987, Mr. Clendenen filed

joint U.S. Individual Income Tax Returns. For 1988 through 1991,

he filed his returns with a filing status of single.2 Mr.

Clendenen's returns reflect the following: 

 Wages, Business

Year Salaries Income Type of Business

1986 $12,938 0

1987 30,000 0

1988 0 0

1989 0 $75,000 Insurance consulting

1990 0 60,000 Consultant

1991 0 55,000 Consultant

For the plan year ending June 30, 1986, and his taxable year

ending December 31, 1986, Mr. Clendenen treated $17,029.38 as an

elective deferral of compensation into the ESOP. 

Discussion

Section 401(a)(16) provides:

A trust shall not constitute a qualified trust under

this section if the plan of which such trust is a part
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3 Sec. 415(c)(1)(A) was amended by the Tax Reform Act of

1986, Pub. L. 99-514, sec. 1106(a), 1106(i), 100 Stat. 2420,

2425, effective for years beginning after Dec. 31, 1986, to read

"$30,000 (or, if greater, 1/4 of the dollar limitation [$90,000]

in effect under subsection (b)(1)(A))". It was further amended

to eliminate the parenthetical language effective for years

commencing after Dec. 31, 1994. Uruguay Round Agreements Act,

Pub. L. 103-465, sec. 732(b)(2), 108 Stat. 5005 (1994). 

provides for benefits or contributions which exceed the

limitations of section 415. 

Section 415(a)(1) provides that a trust which is part of a

pension, profit-sharing, or stock bonus plan shall not constitute

a qualified trust under section 401(a) if--

(B) in the case of a defined contribution

plan, contributions and other additions under the

plan with respect to any participant for any

taxable year exceed the limitation of subsection

(c) * * * [.] 

Section 415(c)(1) provides:

Contributions and other additions with respect to a

participant exceed the limitation of this subsection

if, when expressed as an annual addition (within the

meaning of paragraph (2)) to the participant's account,

such annual addition is greater than the lesser of --

(A) $30,000,[3] or

(B) 25 percent of the participant's compensation.

Section 415(c)(2) provides that "annual addition" means the sum

for any year of--

(A) employer contributions,
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4 Sec. 415(c)(2)(B) was amended by the Tax Reform Act of

1986, Pub. L. 99-514, sec. 1106(e)(1), 1106(i), 100 Stat. 2424,

2425, for the years beginning after Dec. 31, 1986, to include the

entire employee contribution in the computation of the annual

addition. 

(B) the lesser of--

(i) the amount of the employee contributions

in excess of 6 percent of his compensation, or

(ii) one-half of the employee

contributions,[4] and

(C) forfeitures.

The dispute in this case focuses on the amount of the

contributions to the trust allocated to Mr. Clendenen. The

parties disagree as to what constitutes participant compensation

and as to whether elective deferral amounts constitute employee

or employer contributions. It is petitioner's position that the

amounts of elective deferrals are employee contributions and

should be included in "participant's compensation". Petitioner

also asserts that "participant's compensation" includes amounts

petitioner paid as commissions and bonuses to Mr. Clendenen as an

independent contractor. As a consequence, petitioner maintains

that the limitations of section 415(c)(1) have not been exceeded

with the result that the plan and trust were qualified during the

years at issue.

Respondent asserts that the amounts of elective deferrals

constitute employer, not employee, contributions and that these

amounts and the commissions and bonuses do not constitute
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5 This provision was renumbered as sec. 1.415-2(d)(3)(i),

Income Tax Regs., effective for years after Jan. 1, 1987. T.D.

8361, 1991-2 C.B. 310, 318.

"participant's compensation". Such being the case, respondent

contends that the limits of section 415(c)(1) were exceeded, and

the plan and trust were not qualified during the years at issue.

Section 415(c)(3)(A) simply defines participant's

compensation as "the compensation of the participant from the

employer for the year." However, section 402(a)(8) provides:

For purposes of this title, contributions made by an

employer on behalf of an employee to a trust which is a

part of a qualified cash or deferred arrangement (as

defined in section 401(k)(2)) shall not be treated as

distributed or made available to the employee nor as

contributions made to the trust by the employee merely

because the arrangement includes provisions under which

the employee has an election whether the contribution

will be made to the trust or received by the employee

in cash. [Emphasis added.] 

Also, section 1.415-2(d)(2)(i), Income Tax Regs.,5 provides that

compensation does not include "Contributions made by the employer

to a plan of deferred compensation to the extent that, before the

application of the section 415 limitations to that plan, the

contributions are not includable in the gross income of the

employee for the taxable year in which contributed." 

Furthermore, section 1.401(k)-1(a)(4)(ii), Income Tax Regs.,

provides:

Except as provided in paragraph (f) of this section,

[dealing with the correction of excess contributions]

elective contributions under a qualified cash or

deferred arrangement are treated as employer
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6 The Small Business Job Protection Act of 1996, Pub. L.

104-188, sec. 1434(a), 110 Stat. 1807, added sec. 415(c)(3)(D)

which includes certain deferrals in participant's compensation,

effective for years beginning after Dec. 31, 1997. This

amendment does not apply to the instant case. We note, however,

that the legislative history makes clear that Congress considered

the provisions of the then-existing law as requiring the result

reached herein and specifically intended to change the law for

future years. H. Rept. 104-586 at 112 (1996), 1996-3 C.B. 331,

450; S. Rept. 104-281 at 80 (1996); H. Conf. Rept. 104-737 at

245-246 (1996), 1996-3 C.B. 741, 985-986. 

7 Since the years involving the elective deferrals are

fiscal years ending June 30, 1986, and June 30, 1987, only a

portion of the employee contributions would have been included. 

Sec. 415(c)(2)(B); see supra note 4.

contributions. Thus, for example, elective

contributions are treated as employer contributions for

purposes of sections 401(a) and 401(k), 402, 404, 409,

411, 412, 415, 416, and 417.

The issue in respect of elective deferrals has been before

this Court under substantially identical circumstances. See

Steel Balls, Inc. v. Commissioner, T.C. Memo. 1995-266, affd.

without published opinion 89 F.3d 841 (8th Cir. 1996).6 We

rejected the same argument presented herein and concluded that

respondent's position was clearly supported by the statute and

regulations. We reach the same conclusion herein and hold that

the elective deferrals are employer contributions and not

included in "participant's compensation". Consequently, the

amounts of the elective deferrals are included in annual

additions.7 Sec. 415(c)(2).

Petitioner also seeks to include in "participant's

compensation" the amounts of the commissions or bonuses that
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8 See supra note 5.

petitioner paid Mr. Clendenen as an independent contractor for

the years 1989 through 1991. Petitioner argues that Mr.

Clendenen's compensation was his earned income as a self-employed

person. Petitioner is correct that for a self-employed

individual, "participant's compensation" is the participant's

earned income. See sec. 415(c)(3)(B). What petitioner fails to

recognize is that a sole proprietor is considered to be his own

employer. Sec. 401(c)(4); sec. 1.401-10(e), Income Tax Regs. 

Mr. Clendenen, thus, had at least two employers during 1989,

1990, and 1991, himself and petitioner. 

While an individual can be an employee with respect to more

than one business or employer, each employer is considered

separately and only the income the employee earns from the

employer sponsoring the plan may be taken into account for

purposes of that employer's plan. Sec. 415(c)(3)(A)

(compensation "from the employer"); sec. 1.401-10(b), Income Tax

Regs. Accordingly, section 1.415-2(d)(2)(i),8 Income Tax Regs.,

provides:

For purposes of applying the limitations of section

415, the term "compensation" includes * * * --

(i) The employee's wages, salaries, fees for

professional services, and other amounts received * * *

for personal services actually rendered in the course

of employment with the employer maintaining the plan to

the extent that the amounts are includable in gross

income * * * . [Emphasis added.]
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9 The amounts deducted by petitioner as officer

compensation on its returns for 1986 and 1987 do not match those

reported by Mr. Clendenen on his individual returns. While this

could be due to the different tax years involved (year ending

June 30 versus December 31), respondent, in the revocation letter

and in his briefs, uses the lower figures appearing on Mr.

Clendenen's returns due to lack of substantiation. Petitioner

does not address the difference for 1986, and for 1987, uses the

lower figure in its brief. For 1989 through 1991, respondent

treats the amounts shown as salaries and wages on petitioner's

corporate returns as compensation paid to Paul Clendenen. 

Petitioner does not argue that these amounts were paid to Mr.

Clendenen. 

For purposes of petitioner's plan, Mr. Clendenen is covered as an

employee of petitioner and thus, only with respect to the

compensation received as petitioner's employee. We do not

dispute petitioner's argument that Mr. Clendenen was an officer

of petitioner and that an officer is an employee. But the fact

of the matter is that petitioner adopted an arrangement whereby

Mr. Clendenen was not compensated for whatever services he may

have rendered as an officer-employee but for his services as an

independent contractor. We hold, therefore, that the amounts

petitioner paid to Mr. Clendenen as an independent contractor are

not includable in compensation.

We now determine whether the annual additions on behalf of

Mr. Clendenen exceed the section 415(c) limits. With the

exception of 1988, for which the parties agree Mr. Clendenen's

compensation was $0, the record is not clear as to the exact

amounts of compensation paid to Mr. Clendenen.9 We need not make

any findings with respect to the exact figures, however, for
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regardless of which amounts we use, the annual additions

allocated to Mr. Clendenen during each of the plan years 1986,

1987, 1989, 1990, and 1991, exceed the section 415 limits. 

Petitioner has not argued or established that any corrective

measures were taken to reduce these additions. See sec. 1.415-

6(b)(6), Income Tax Regs.

We hold that the trust is not a qualified trust under

section 401(a) beginning with the plan year 1986.

Decision will be entered

for respondent.