District court says excise taxes were inappropriate when plan was not harmed.

A U.S. district court has held that imposition of the Sec. 4971 underfunding excise tax was unwarranted when the underfunding was a result of a book entry misallocation of funds between a pension plan and a profit-sharing plan, and neither the plans nor the sole participant was harmed. The court also held that even though the participant waited 2 1/2 years to record a mortgage he had given as security for a plan loan, imposition of the Sec. 4975 prohibited transaction excise tax was inappropriate when the plan suffered no harm (Ahlberg, DC Minn., 1991).

In January 1980, a professional association established a pension and a profit-sharing plan. Daniel Ahlberg, its sole shareholder and employee, was the sole participant and the administrator of both plans. For 1980, 1981 and 1984, the corporation made the maximum allowable contribution to the plans, paying the funds into a commingled money market account for the plans' benefit. Although the total contribution for each of those years was correct, book entry errors resulted in an incorrect allocation between the pension and profit-sharing plans. This misallocation, which resulted in an underfunding of the pension plan, was corrected by a book entry, requiring no transfer of funds and resulting in no loss of interest. Nevertheless, the IRS imposed the excise tax under Sec. 4971 for failure to meet the Sec. 412 minimum funding standards.

Ahlberg twice borrowed funds from the plans. In each case, he gave the plan a promissory note secured by a mortgage in real estate. However, he waited 10 months before recording the mortgage that secured the first loan - and 2 1/2 years before recording the mortgage that secured the second loan. The Service imposed the Sec. 4975 prohibited transaction excise tax on Ahlberg, claiming that as a result of his delay in recording the mortgages, the loans were not adequately secured (as required by Sec. 4975(d)(1)(E)).

The district court found that the misallocation between the pension plan and the profit-sharing plan was merely a bookkeeping error, did not cause the plans or Ahlberg any harm and did not give Ahlberg any extra benefit. On that basis, the court held that the IRS's imposition of the Sec. 4971 excise tax was inappropriate.

The court also recognized that Ahlberg's delay in recording the mortgage created the opportunity for a third party to establish a lien against the real estate with rights superior to Ahlberg's mortgage. However, since that event did not occur, the plans were not harmed. Moreover, since Ahlberg was the sole beneficiary of the plan, any harm the plan might have suffered would have harmed only him. Thus, the Service's imposition of the prohibited transaction tax also was unwarranted.

Compare the approach in this case with the Tax Court's approach in Zabolotny, 97 TC No. 27 (1991). In Zabolotny, the Tax Court upheld prohibited transaction penalties of almost $8.5 million against a married couple in connection with their sale of land to an employee stock ownership plan (ESOP) in which they were the sole participants - even though the land proved to be an exceptionally good investment for the ESOP.