Substantial Compliance No Substitute for Filing Election

A taxpayer's sale or exchange of investment securities generally does not qualify for nonrecognition of gain as a like-kind exchange. However, when taxpayers (other than C corporations) sell securities that they have held for at least three years in a C corporation that isn't publicly traded to an employee stock ownership plan (ESOP), they can elect not to recognize gain on the sale and reinvest the proceeds in replacement The nonrecognition of gain is temporary if the taxpayer subsequently disposes of the replacement property by other than a corporate reorganization, death or gift. Under a duly flied election, in the event of a taxpayer's death, the reproperty is included in his or her gross estate at fair market value, thus permanently avoiding federal income tax on the deferred gain. To qualify for nonrecognition treatment, transfers must meet the requirements of IRC section 1042, Sales of Stock to Employee Stock Ownership Plans or Certain Corporations. Section 1042(a) provides for nonrecognition of gain if (1) The taxpayer or executor elects in such form as the secretary of the Treasury may prescribe to apply this section to any sale of securities. (2) The taxpayer purchases replacement property within the replacement period. (3) The requirements of subsection (b) are met with respect to the sale. Then the gain--if any--on the sale would be recognized as long-term capital gain only to the extent the amount realized on the sale exceeds the cost to the taxpayer of the replacement Treasury regulations section 1.1042-1T prescribes what form the required not to recognize gain on the sale of securities must take. It must be a written of election attached to the taxpayer's income tax return and filed on or before the due date (including extensions) for the taxable year in which the sale occurs. The domestic C corporation must consent to the application of IRC sections 4978 and 4979A in a written statement filed with the return. Taxpayers who fail to make a timely cannot subsequently make it on an amended return. And once made, elections are irrevocable. In 1995 John W. Clause retired from W.J. Ruscoe Co., a closely held C corporation. At that time he owned over 82% of the company's outstanding shares; he had been the majority shareholder since 1975. Clause did not acquire his shares from a plan distribution described in IRC section 401(a) or through a transfer under an option or other right to acquire stock. At retirement Clause consulted with his accountant and an attorney the accountant believed was familiar with stock sales to ESOPs. The accountant had prepared Clause's tax returns since 1978 but had never prepared a return with a section 1042 transaction. The accountant also prepared the tax returns for W.J. Ruscoe Co. On March 11, 1996, Clause sold all of his shares in Ruscoe to the company's ESOP for $1,521,630. He had owned these shares for more than three years and his basis at the time of the sale was $115,613. Clause deposited the sale proceeds into a brokerage account. On February 18, 1997, he purchased securities issued by domestic corporations, totaling $1,399,775, which satisfied the requirement of section 1042(c)(4) as qualified replacement property. While Clause timely filed his 1996 federal tax return, he did not report the sale of stock to the ESOP--in any manner--on the return. The original 1996 tax return did not include the statements of and consent required under section 1042. On November 28, 2000, during the IRS examination of Clause's original tax return, his accountant, acting under a power of attorney, filed an amended federal tax return for 1996 reporting a $121,807 gain, based on the amount Clause had not reinvested in replacement …