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Question 71: Treas. Reg. 1.414(c)-4(b)(5)(ii)(A) uses the term "directly." It is commonly believed that "directly" includes community property ownership. For example, if a spouse never actually held shares of a business in his or her name but the business (or some portion thereof) is community property, then the exception cited in that regulation would be inapplicable. Does the term "directly" include community property ownership? |
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Answer: Let's first look at the regulation in question:
Notice that the opening of this regulation uses the phrase "directly or indirectly." Indirect ownership is generally regarded as ownership by operation of the attribution rules. Thus, if I have an option to acquire stock which I do not in fact own, I am considered to be its owner under the attribution rules and I indirectly own the stock. From there, it can be attributed to another person, such as my wife. Having said that, we then consider direct ownership. The direct owner is someone who owns the stock without regard to the attribution rules. Direct ownership is determined by reference to state law. The Code uses it the same way. For example, Section 1563(d)(2) states:
So, when the regulation says that unless certain conditions are met, my wife is deemed to own any stock I own, whether I own it directly or indirectly, it means she is treated as owning the stock if I am either the legal owner or the owner under the attribution rules. One of the conditions of what I call the noninvolvement exception, which is outlined in the regulation you cite and in section 1563 of the Code, is that my wife cannot own any of the stock "directly." In other words, my wife cannot legally own any of the stock, even though she may own it indirectly, such as by attribution from one of our children or from a trust. In the case of Aero Industrial Co., Inc., (1980) TC Memo 1980-116, the court determined that for purposes of section 1563 community property ownership was direct ownership. The Aero Industrial case involved a mother who owned 2/3 of one business and 100% of another. The remaining 1/3 was owned by her son-in-law. There is no attribution between the son-in-law and the mother. Because the son-in-law did not own any stock of one corporation, the rule in the U.S. Supreme Court case of Vogel Fertilizer v. Commissioner excludes him from consideration. The mother owned less than 80% of one of the corporations and so, at first glance, it appeared there was not a controlled group. However, the son-in-law received his stock as compensation for services rendered to the company. As such, under state law, his stock was community property, even though it was in his name alone. Hence, under state law, the mother owned 67%, her daughter owned 16%, and the son-in-law owned 16%. The daughter's shares, which she owned directly (and not by attribution from her husband) were attributed to her mother. The mother was deemed to own 83% of the company, thus creating a controlled group. (Had the daughter owned her shares, indirectly, by operation of the attribution rules, attributing her ownership to her mother would have been prohibited under the rules against double family attribution.) Here's an excerpt of the discussion of this issue in Chapter 7 of my book, Who's the Employer?:
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Answers are provided as general guidance on the subjects covered in the question and are not provided as legal advice to the questioner or to readers. Any legal issues should be reviewed by your legal counsel to apply the law to the particular facts of this and similar situations.
The law in this area changes frequently. Answers are believed to be correct as of the posting dates shown. The completeness or accuracy of a particular answer may be affected by changes in the law (statutes, regulations, rulings, court decisions, etc.) that occur after the date on which a particular Q&A is posted.
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