Clause is of interest not just because it teaches how not to obtain the benefits of a Sec. 1042 deferral, but also because it revisits the doctrine of substantial compliance.

Several Code sections and their regulations require certain elections, informational statements and other specific actions on the part of taxpayers to obtain desired tax consequences. Some of these required actions  are unambiguously set forth in the statutes; others are statutorily delegated to Treasury to carry out the statutes substance. Sec. 1042 is a prime example of a statute requiring certain actions on a taxpayers part, including a Sec. 1042(a)(1) election that is to be in such form as the Secretary may prescribe. 

What happens when a taxpayer fulfills most, but not all, of the necessary actions in the manner and form required? The doctrine of substantial compliance may apply.

The Tax Court has indicated that  there exists no litmus test for determining whether literal compliance with a procedural regulation is called for  (Hewlett-Packard Co., 67 TC 736, 748 (1977)). Rather, a review is required to determine whether literal compliance is needed. The purpose and terms of the underlying statute, as well as the consequences of a failure to comply with the relevant provision, must be taken into account; see Octavio J. Valdes, 60 TC 910 (1973). Going as far back as 1928, the Board of Tax Appeals framed the question as [w]hat is the essence of the thing required to be done by this statute?  (Indiana Rolling Mills Co., 13 BTA 1141 (1928)). Lastly, the doctrine can cut both ways; it has been invoked by both taxpayers and the Service alike.

For nearly 40 years, John Clause worked for W.J. Ruscoe Co., a closely held corporation. In 1996, a year after his retirement, he sold all of his Ruscoe stock to an ESOP established by the company, for $1,521,630. Within a year of the sale, he purchased  qualified replacement property,  which met the Sec. 1042(c)(4) requirements, totaling approximately $1.4 million, leaving only $120,000 of unreinvested proceeds.

Unfortunately for Clause, his CPA had no experience with stock sales to ESOPs. The CPA prepared (and Clause timely filed) the 1996 return without reporting the sale. Further, the return did not include any of the statements required by Sec. 1042, nor mention or refer to the stock sale.

In early 1999, the IRS examined Clauses 1996 return. In November 2000, Clause filed an amended 1996 return, reporting $120,000 gain (i.e., proceeds not reinvested ). In July 2001, Clause received a deficiency notice for 1996 that included the gain of approximately $1.4 million from the stock sale to the ESOP. In October 2001, Clause filed a second amended 1996 return that included a statement of election under Sec. 1042 and the other required statements. Additionally, Clause filed a Tax Court petition.

The Tax Court reiterated the Sec. 1042 statutory requirements, which mandate, among other things, a statement of election to apply Sec. 1042 to the sale, and a written verification statement from the employer authorizing consent to the application of Secs. 4978 and 4979A. Such statements must be included with a timely filed return.

The Tax Court determined that Temp. Regs. Sec. 1.1042-1T, which sets forth the form of election, is a legislative regulation and, as such, is given controlling weight unless it is arbitrary, capricious, or manifestly contrary to the statute  (citing the Supreme Court in Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 US 837, 844 (1984)).

Clause argued that he substantially complied with the Sec. 1042 requirements and that the election requirements set forth in the statute and regulation were purely administrative in nature.  The Tax Court, in holding in the IRSs favor, stated that substantial compliance is no defense to a failure to comply with the statutes essential requirements. Further, it distinguished the present case from its numerous prior decisions on the applicability of the substantial compliance doctrine. In pro-taxpayer cases, most of the information required was provided with an original return and the information omitted was deemed insignificant; see, e.g., Bond, 100 TC 32 (1993), and Hewlett-Packard. As Clause filed his return without mentioning the sale, the court deemed the substantial compliance defense inapplicable.