Defining an Affiliated Group

A n affiliated group of corporations can elect to file a consolidated tax return. One of the advantages of doing so is the ability to net a loss from one corporation against the profits of another. To be a member of an affiliated group, the group must own stock representing at least 80% of the voting power and 80% of the value of the subsidiary. A recent case explored the definition of voting power.

Amax, Inc., and a group of Japanese businesses owned the stock of Alumax, Inc., a manufacturer of aluminum products. While each owned 50% of the stock, the stock Amax owned had four votes per share, giving Amax 80% of the votes on both corporate issues and the board of directors. However, a majority of the shareholders of both groups had to approve any merger, purchase or sale of 5% of Alumax’s corporate assets and any liquidation, hiring or firing of the CEO or loans to affiliated corporations.

Although the board members Amax elected had 80% of the votes, the directors elected by the Japanese businesses could veto any board action, subject to review by a panel of arbitrators. In addition, Alumax had to pay dividends equal to 35% of its income, 80% of which went to the Japanese investors. Because of these restrictions, the IRS concluded that Amax did not own stock with 80% of Alumax’s voting power.

Result. For the IRS. Neither the code nor the regulations define “80% of the voting power.” The Eleventh Circuit Court of Appeals reviewed the legislative history and prior decisions to determine congressional intent. Historically, voting power has been interpreted as the ability to elect members of the board of directors. Under this definition, Alumax appears to qualify as a member of Amax’s affiliated group. However, that interpretation is based on the assumption that a majority of the board would have the power to control a corporation’s affairs. In this case, the board’s power was limited (1) on certain issues and (2) by the veto granted to the Japanese businesses. Consequently, the court ruled, the affiliated group did not own 80% of the voting power of Alumax stock.

Under normal circumstances, a corporation that owns stock with at least 80% of the votes for board members has control. However, any restriction on either the shareholder’s votes or the board’s actions will cause the IRS to look more closely at the stock ownership.

• Alumax, Inc. v. Commissioner , 11th Cir. 1999, 165 F.3d 822, 83 AFTR 2d 99-505.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

• All tax returns must include a number by which the return preparer can be identified. Currently, individual preparers must use their social security numbers. New regulations, effective for returns filed after December 31, 1999, allow preparers to elect an alternative number. The IRS is developing a form to be used in applying for this number.

Signature Needed

• The Tax Court ruled that a tax return signed by an attorney and submitted to the IRS on behalf of an individual taxpayer was not a valid return because it was not properly signed.

The attorney had written “Under Power of Attorney” on the form 1040, but had not included Form 2848, Power of Attorney and Declaration of Representative , with the return. In addition, neither the taxpayer nor his attorney obtained the consent of the IRS district director for the attorney to file as agent for the taxpayer. As a result, the taxpayer was penalized for failing to file a timely return under IRC section 6651(a) ( Herbert C. Elliot v. Commissioner , 113 TC No. 7, 8-10-99).

Tough Luck on IRA Withdrawal

• The IRS announced it was unable to help a group of taxpayers that took money out of qualified IRAs. The taxpayers believed their tax adviser had invested the funds in qualified tax-free rollover accounts, but he had not. Subsequently, local IRS personnel told them the 60-day rollover period could be waived if the funds were placed in qualified accounts in a reasonable period of time. However, the IRS announced a different position in Field Service Advice 1999-33038. According to the FSA, withdrawals such as those the taxpayers made are currently subject to income tax and a 10% penalty. The FSA also discusses the types of situations in which tax-free treatment is granted.

Court Okays Shareholder Deduction

• The Tax Court held that the $1.75 million a professional service company paid to its sole shareholder was deductible as reasonable compensation. The shareholder was an attorney and the corporation’s only professional employee. The court found his services were vital to the operation of a complex and highly specialized business. The deduction was allowed even though it was partially funded with a loan from the sole shareholder and caused a deficit in the corporation’s retained earnings ( Richard Ashare, PC v. Commissioner , TC Memo 1999-282).

Long-Term T&E

• Generally, a taxpayer away from home on business for more than a year is not allowed to take a deduction for meals or lodging as a business expense. In a recent Tax Court case, however, a self-employed consultant worked for a single client at a distant location over a five-year period. The court concluded the taxpayer could deduct his business travel costs because the work was “on again and off again” in nature and the taxpayer was free to work for other clients ( Mitchell v. Commissioner , TC Memo 1999-283).

Developer Gets to Save A Lot

• In most cases, if a real estate developer purchases a tract of land, subdivides it and sells the parcels, the related profits are taxed as ordinary income. What if legal problems prevent a developer from selling the individual lots to the public as originally planned? If the lots are sold to another developer, the Tax Court allows the profits to be taxed at the lower capital gains rates. According to the court, it is the developer’s intent at the time of sale, not his or her intent at the time of purchase, that matters ( Olstein v. Commissioner , TC Memo 1999-290).

—Michael Lynch, CPA, Esq., professor of tax accounting at Bryant College, Smithfield, Rhode Island.

The earned income credit (EIC) is designed to encourage low-income individuals to become gainfully employed. It is a refundable credit—one that the taxpayer may receive even when no tax is due. In essence, it’s a negative income tax. In many situations, more than one member of the same family may qualify for the EIC. The question is, Who is entitled to take it?

IRS Service Center Advice 1998-048 explains how an EIC tiebreaker works in some family situations.

A grandmother, her daughter (mother) and her granddaughter live together for the entire tax year. The mother meets the EIC age requirement so she is a qualifying child of the grandmother. (A qualifying child for the EIC must be under 19, under 24 if a full-time student, or permanently and totally disabled.)

If the granddaughter is a qualifying child of both her grandmother and mother, IRC section 32(c)(1)(C)—the tiebreaker rule—should apply, but it doesn’t. Instead, IRC section 32(c)(1)(B) applies. It says if an individual, such as the mother, is a qualifying child of another taxpayer (the grandmother, in this example), then she is not treated as an eligible individual for EIC purposes. Therefore, the grandmother is the one who can claim the credit for both her daughter and her granddaughter.

If the mother is too old to satisfy the age requirement, she is not a qualifying child of the grandmother. Thus, the tiebreaker rule would apply. It states that when two or more eligible individuals qualify with respect to the same child, only the individual with the highest modified adjusted gross income can claim the credit.

In recently released Legal Memorandum 1999-34017, the IRS explained how the tiebreaker rule applies if both grandparents are alive.

Assume the mother is 25 years old with a modified AGI of $9,000. The grandparents have a combined modified AGI of $12,000 ($8,000 for the grandfather and $4,000 for the grandmother).

If the grandparents file a joint return, they get the credit under the tiebreaker rule because their combined modified AGI ($12,000) is higher than the mother’s ($9,000). However, if the grandparents file separate returns, the mother could claim the credit because she has the highest separate modified AGI. Even if one of the grandparents had a higher separate modified AGI than the mother’s, that grandparent could not claim the credit because IRS section 32(d) requires married individuals to file a joint return in order to claim it.

Observation. The tiebreaker rule operates to award the credit to the individual with the highest income. Since the EIC phases out when a taxpayer’s income reaches a certain level, not everyone can claim the credit.

In addition, separate residencies can bar some families from taking advantage of the EIC. For instance, if the mother and the granddaughter in the examples above lived on their own for more than six months of the tax year, then the residency rule of IRC section 32(a)(3)(B)(iii) would prevent the grandparents from claiming the credit.

—, CPA, Esq., professor of tax accounting at Bryant College, Smithfield, Rhode Island.