Controlled Group - Spousal Attribution

[LANDO]

I have a situation where Husband owns 100% of one business and Wife owns 100% of an unrelated business.  Husband's business maintains a 401(k) plan for it's employees.

Wife is an employee of Husband's business.  They have a pre-nuptial agreement regarding the ownership of their own businesses, so there are no "direct" ownership issues.

We have told them the two businesses are related because they do not qualify for the exception under IRC 1563(e) because the Wife is an employee of Husband's company.  She is also a participant in the 401(k) plan her Husband's company maintains...probably the reason she's an employee in the first plan, but that is besides the point.  They have come back an said the conditions under 1563(e)(5)(B) are satisfied even though the Wife IS and employee of Husband's business since she "does not participate in the management" of the Husband's business.  Their interpretation is that the "and" underlined below means both conditions must be satisfied (employee and participate in management) for the condition to be considered not met.

1563(e)(5)(B) 

The individual is not a director or employee and does not participate in the management of such corporation at any time during such taxable year;

 

I do not see anything in the Code or Regulations that clarifies this point.  I have always interpreted this section to mean that if a spouse is an employee or director, the spousal attribution exception does not apply.  I would read the part about not participating in the management as a separate condition.  None of the articles I can find on the subject address the "management" language in 1563(e)(5)(B).

Seems contrary to the general intent of the rules around spousal attribution to say the spouse can be an employee and participate in the plan, but the spousal attribution rules can be ignored as long as the sponsor is willing to say the spouse doesn't participate in the management of the sponsor.

Anyone have thoughts on this?  Authority for either position? 

 

 

 

 

 

[duckthing]

So they're interpreting "The individual is not a director or employee and does not participate in the management of such corporation at any time during such taxable year" to mean "The individual is not a director or employee, or is a director or employee who does not participate in the management of such corporation at any time during such taxable year"?

[ETA Consulting LLC]

Is the individual a director?
Is the individual an employee?
Does the individual participate in in the management of the corporation?

If all three of these are "NO", then you're not attributed the ownership.  If any one of the three are "Yes", then you're attributed ownership.

Good Luck!

[Belgarath]

They like to live dangerously, eh? You could recommend that if they don't like your interpretation, they should try putting it in front of an ERISA attorney. Or possibly an English professor.

P.S. If I didn't make it clear, I'm not casting aspersions on YOUR interpretation, but rather their reading of the language. I agree with you, and ETA put it nicely and succinctly.

[LANDO]

English professor...that's a good one!  Thanks for the support, and "No" the Wife is not a director, and purportedly not involved in the management of the Husband's business.

I have subsequently found the following resource (link below, see page 17 of 94) which is apparently a training outline the IRS put together for Enrolled Agents. That does support that each element, per ETA's comment above, must be satisfied.  I haven't found anything else particularly useful, but I will be referring them to their own ERISA counsel if they insist on their interpretation.

https://www.irs.gov/pub/irs-tege/2013cpe_related_employers.pdf

 

[cathyw]

The suggestion of consulting with an English professor is exactly right!  The client is not reading the code section properly.  The general rule of 1563 is that there is attribution between spouses.  Then there is an exception to attribution.  The exception will apply if:

The individual is not a director or employee and does not participate in the management of such corporation at any time during such taxable year

 If either the condition before the "and", or the condition after the "and" are applicable, the exception does not apply.

[JamesK]

It's an interesting question and I spent zero time looking for any IRS or court interpretations of this requirement other than reading the statute and the relevant regulation (no differences).  But on its face, I think your clients are correctly applying the ordinary meaning of the word "and".   

"Ordinarily, as in everyday English, use of the conjunctive "and" in a list means that all of the listed requirements must be satisfied, while use of the disjunctive "or" means that only one of the listed requirements need be satisfied."

Therefore, since all of the requirements are not satisfied (i.e., the one spouse does not participate in the management of the other spouse's corporation), then that individual/spouse satisfies the requirement that they are not a member of the board of directors, not an employee, and do not participate in the management of such corporation. 

I know that with the double negatives, it gets confusing, but I believe that they are correct.  Just an opinion though.  There are instances where a court has interpreted "and" as disjunctive but those are relatively few and far between.  Context is, of course, everything. 

The source of the quote above can be found here:

  https://www.everycrsreport.com/reports/97-589.html 

[Larry Starr]

5 hours ago, JamesK said:

It's an interesting question and I spent zero time looking for any IRS or court interpretations of this requirement other than reading the statute and the relevant regulation (no differences).  But on its face, I think your clients are correctly applying the ordinary meaning of the word "and".   

"Ordinarily, as in everyday English, use of the conjunctive "and" in a list means that all of the listed requirements must be satisfied, while use of the disjunctive "or" means that only one of the listed requirements need be satisfied."

Therefore, since all of the requirements are not satisfied (i.e., the one spouse does not participate in the management of the other spouse's corporation), then that individual/spouse satisfies the requirement that they are not a member of the board of directors, not an employee, and do not participate in the management of such corporation. 

I know that with the double negatives, it gets confusing, but I believe that they are correct.  Just an opinion though.  There are instances where a court has interpreted "and" as disjunctive but those are relatively few and far between.  Context is, of course, everything. 

The source of the quote above can be found here:

  https://www.everycrsreport.com/reports/97-589.html 

Sorry; wrong.  They are not reading it right.  The "non-involvement" provision means just that. ABSOLUTELY NO INVOLVEMENT, including as an employee OR (even if not an employee) in providing any management to the business. This is not controversial.

Here is the information from Derrin Watson's book Who's The Employer; note condition 2.

Q 9:17 What is the noninvolvement exception to spousal attribution?   

Unless — heaven forbid! — we divorce or are legally separated, I will be deemed to own any stock owned by my wife unless the stock is of a corporation that meets all four of the following conditions: [Code §1563(e)(5); BL 242]

1. I own no stock in that corporation directly.

2. I am not a director or employee and I do not participate in management of the corporation at any time during the year. See Q 12:4 to apply this rule to entities other than corporations.

3. Not more than 50% of the corporation’s gross income (determined for normal income tax purposes) is derived from royalties, rents, dividends, interest, and annuities, as defined in Treas. Reg. §1.1244(c)-1(e)(1)(ii)-(vi). [Treas. Reg. §1.1563-3(b)(5)(iii)]

4. The stock is not subject to restrictions limiting my wife’s right to dispose of the stock which run in my favor or in favor of my children under age 21. Rights of first refusal or the power to block sale are examples of such restrictions. [Treas. Reg. §1.1563-3(b)(5)(ii)(d)]

Naturally, these four conditions are the same regardless of the gender of the parties.

Example 9.17.1 Emilee owns 100% of Emilee’s Quilts, a corporation which derives all its income from sales of merchandise. Her husband, Steve, owns no stock in the company and there are no restrictions on Emilee’s stock. Steve isn’t an officer, director, employee, or otherwise involved in the company. Steve is not deemed to own the stock.

Example 9.17.2 Assume the same facts as Example 9.17.1, except Steve is listed as vice president of the company (so he can sign checks and run the business if Emilee is ill). The noninvolvement exception no longer applies, since Steve is an officer. He is deemed to own 100% of the stock.

Of these four conditions, the most problematic is the first, that I cannot own any of the stock directly. What does that mean? It means I do not actually, legally own any stock in the company. No attribution rules apply. If I do not actually own any stock, but I have an option to buy the stock from a third party, I still have no direct ownership in the stock.

A question arises regarding community property. Community property ownership is direct ownership. Under the laws of each community property state, if stock is held as community property, each spouse has an equal ownership of the stock. Under certain circumstances, one spouse may have the sole right to manage the stock, but that does not change the fact that both spouses own it. Generally, the title under which the stock is registered or held is irrelevant. [BL 71]

Example 9.17.3 John married Mary as John was finishing medical school. He now has a successful incorporated medical practice. All of the stock of the practice is in John’s name. Mary is a prosperous accountant but cannot practice medicine. The couple lives in California, a community property state. Under California law, absent an agreement to the contrary, the stock in John’s professional corporation is community property. If John and Mary divorce, Mary will be entitled to half of the value of the practice. Even without the divorce, she is entitled to half of the income from the practice. It does not matter that she cannot be a shareholder of a medical corporation. Under California law, she has an ownership interest equal to John’s in the practice.

This means that both spouses have a direct ownership in community property assets. Their ownership does not come through attribution. It comes by operation of state law, just as any other ownership does. This was the holding of the court in the Aero Industrial case discussed at Q 8:15.

Hence, if stock is held as community property, it is impossible for the stock to meet the first condition. Therefore, until there is a legal separation or a divorce [Q 9:16], each spouse is deemed to own 100% of any stock held by either or both of them as community property. Each owns 50% directly, and 50% by spousal attribution.

Some practitioners take a different approach, believing community property ownership should not be treated as direct ownership. These practitioners feel that Congress “clearly intended” to create a spousal exception and would not have wanted to make a difference between community and separate property states. The author disagrees. Congress knows how to put community property and separate property jurisdiction on an equal footing and did not do so. [Compare Code §§219(f)(2), 402(e)(4)(D)(iii), 402(g)(5), and 408(g)] The courts have held for years that community ownership is real, direct ownership, sufficient to allow for perhaps the most important tax distinction between separate and community property states, income splitting even without a joint return.

Example 9.17.4 Continuing Example 9.17.3, suppose that Mary owns 100% of the stock of her accountancy corporation. If either corporation is held as community property, then the two are a controlled group for ordinary income tax purposes and employee benefit purposes. Because of the community ownership, the noninvolvement exception does not apply.

There is a way around this rule for those in community property states. The couple can have their stock treated as separate property. Usually, this is accomplished through an agreement between the parties, signed before or after the marriage.

However, such an agreement has serious side effects. If the parties divorce and one corporation is worth more than the other, the agreement will impact what the parties receive in the divorce. The availability of such an agreement is an additional reason community property ownership should be treated as direct ownership. The parties have the ability to put themselves on the same footing as those in separate property states. Why should they have the ability to choose between the consequences of the status of their property? It is either community and attributed, or separate and not attributed assuming the other conditions are met.

Truly, entering into such an agreement to clear up a pension problem is a case of the “tail wagging the dog.” Such an agreement should not be considered, even in a friendly situation, unless husband and wife are separately represented by experienced counsel. In some states, such an agreement is potentially invalid after marriage unless each party has separate counsel.

Example 9.17.5 Continuing Example 9.17.4, suppose John and Mary enter into a legally binding agreement that each spouse owns the stock in his or her corporation as separate property. As of the date agreement is signed, assuming the other conditions of the noninvolvement exception are met, the two corporations are no longer in a controlled group.

 

[JamesK]

@Larry Starr  The weight of opinion and experience is clearly on your side. 

All I can say is that Treasury could have eliminated the ambiguity by using "or" in place of "and."  Unfortunately, this would have contradicted the statute and raised the question of whether Treasury was rewriting Congress' expressed intent.  In any case, thanks for offering up your thoughts.  I couldn't possibly disagree if the intent of the statute was to eliminate all spousal involvement.