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Zinniel v. Commissioner of Internal Revenue

decided: September 6, 1989.


Appeal from the United States Tax Court, Nos. 31100-84, 31101-84, 31102-84, Thomas B. Wells, Judge.

Cudahy and Ripple, Circuit Judges, and Hubert L. Will, Senior District Judge.*fn*

Author: Ripple

RIPPLE, Circuit Judge

This is an appeal from the Tax Court's denial of the appellants' motion for litigation costs. On June 6, 1984, the Commissioner of Internal Revenue (Commissioner) issued a notice of tax deficiency to the appellants. The appellants filed timely petitions in the Tax Court for the redetermination of the deficiencies. The Tax Court then ruled in favor of the taxpayers. On September 28, 1987, the appellants filed a motion for litigation costs pursuant to 26 U.S.C. § 7430 (now amended).*fn1 The Tax Court denied this motion on December 8, 1987. The appellants now appeal that denial. We conclude that the Commissioner's position in issuing a deficiency against the appellants was not unreasonable and affirm the order of the Tax Court.



A. Introduction

The appellants, John C. Zinniel and Gayle A. Zinniel, David N. Merryfield and Jane A. Merryfield, and James G. Samuels and Margaret Samuels are the taxpayers in this action (collectively taxpayers). The underlying action from which the taxpayers seek litigation costs dealt with whether a Subchapter S election for the taxpayers' corporation, Sierra Limited, had been properly terminated under the statute then governing such terminations, 26 U.S.C. § 1372(e)(1), and the proposed regulations thereunder.*fn2 The Commissioner contended that, in order to terminate properly a Subchapter S election, section 1372(e)(1) required new shareholders to file a document with the Internal Revenue Service (IRS) indicating that the shareholders refused to consent to the election. The taxpayers' position was that section 1372(e)(1) only required that the "refusal to consent" document be filed with the corporation. The Tax Court rejected the Commissioner's argument and held in favor of the taxpayers. Zinniel v. Commissioner, 89 T.C. 357 (1987). Having prevailed on the merits, the taxpayers filed a motion requesting that the Commissioner pay reasonable litigation costs incurred by the taxpayers in that action pursuant to 26 U.S.C. § 7430.

B. The Underlying Transaction

Sierra Limited (Sierra) is a Wisconsin corporation that was incorporated in 1976. At the time of incorporation, John Zinniel, David Merryfield, and James Samuels each owned one-third of the outstanding 900 shares of stock in Sierra. Sierra made an election to be taxed as a Subchapter S corporation. The election was first effective for Sierra's taxable year ending March 31, 1977. During 1977, Sierra decided that it would adopt a qualified pension plan. Because such a plan could not be established while Sierra was still an S corporation, it was necessary to terminate the S corporation status.

Prior to 1976, section 1372(e)(1) required new shareholders to consent affirmatively to the corporation's Subchapter S election within the time prescribed by the Secretary's regulations.*fn3 Inaction meant the S corporation status terminated. This arrangement resulted in the inadvertent termination of Subchapter S elections when new shareholders failed to file this statement of affirmative consent. Therefore, on October 4, 1976, Congress amended section 1372(e)(1) to require that a new shareholder must refuse affirmatively the Subchapter S election.*fn4 Inaction meant the S corporation status remained.

Upon consultation with counsel, the taxpayers were advised that the termination of a Subchapter S election could be effected by

a gift of $3,000.00 worth of stock to each spouse of present stockholders and they, in turn, will file a notification with the Internal Revenue Service that they do not consent to be treated as stockholders in a Subchapter S Corporation.

Appellee's Br. at 4.*fn5 Therefore, on November 30, 1977, each of the three Sierra shareholders transferred thirty shares of Sierra stock to his wife. At that time, a document entitled "Refusal to Consent to Small Business Corporation Election" (Refusal to Consent) was executed by the wives and submitted to Sierra. It stated that the wives would not consent to Sierra's being treated as a small business corporation under section 1372 of the Internal Revenue Code (Code). This document -- the focus of this litigation -- was not filed with the IRS within the sixty-day period allowed by the statute for making such a refusal.

On the same date, November 30, 1977, a Form 5301 -- Application for Determination for Defined Contribution Plan -- was filed with the IRS. This form recited that Sierra was a corporation, not an S corporation. The IRS issued a favorable determination letter regarding the qualified status of Sierra's employee pension plan.

Sierra filed its income tax return on March 31, 1978 and attached a letter stating that Sierra's status as an S corporation had terminated when the new shareholders had affirmatively refused to consent to the election. The Refusal to Consent was not attached to the letter. At the request of the IRS, on December 28, 1978, Sierra's accountant forwarded to the IRS the Refusal to Consent.

For the years ending March 31, 1978 and March 31, 1979, Sierra reported its taxable income as if it were a corporation. The parties stipulated that, at all times relevant to this controversy, there were no regulations, letter rulings, or revenue procedures regarding the new method for terminating a Subchapter S election. R.19 at 9. Each of the three couples also reported their income and any earnings from Sierra as if Sierra were a corporation. On April 17, 1980, Proposed Treasury Regulation 1.1372-3(b)(3) was published under Code section 1372(e)(1).*fn6 This section set forth the requirements for revoking an election as a Subchapter S corporation.

C. The Underlying Litigation

The Commissioner subsequently determined that Sierra's Subchapter S election had not been terminated effectively, and that taxpayers were therefore required to report on their income tax returns for the taxable years in issue the difference between the amount they paid (assuming that Sierra was a corporation) and the amount they owed because the company was still deemed by the IRS to be an S corporation. The Commissioner issued statutory notices of deficiency dated June 6, 1984 that determined deficiencies in taxpayers' income taxes for the taxable years ending December 31, 1978 and December 31, 1979.

Taxpayers filed timely notices for review of these deficiencies by the Tax Court. They claimed that the new shareholders affirmatively had refused to consent to the Subchapter S election by filing the refusal to consent with Sierra within sixty days of the new shareholders' acquisition of the stock. Taxpayers claimed that the plain language of the statute did not require them to file this refusal to consent -- or any other documentation -- with the IRS. There were no regulations in force requiring a filing with the IRS. In the alternative, taxpayers argued that the Proposed Treasury Regulation*fn7 cured any defect in the manner of the election. The Commissioner countered by arguing that, since taxpayers had not filed their refusal to consent with the IRS, no effective termination of the Subchapter S election had occurred. In the Commissioner's view, this result was required by the statute, section 1372(e)(1), even without regulatory supplementation.

The Tax Court decided in favor of the taxpayers. It held that the plain wording of the statute does not require that new shareholders file an affirmative refusal to consent to a corporation's Subchapter S election. Nor could it find that the legislative history reflects an unequivocal congressional intention to require that the native refusal to consent be filed with the IRS in order to effectuate termination. Finally, it held that the proposed regulations "'carry no more weight than a position advanced on brief.'" Zinniel v. Commissioner, 89 T.C. at 369 (quoting F.W. Woolworth Co. v. Commissioner, 54 T.C. 1233, 1265 (1970)); see ...

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