IRC section 382 limits the use of NOL carryforwards following an ownership change. Recently the Tax Court, in a case of first impression, had to decide how the family attribution rules applied in a section 382 context.

When they formed Garber Industries Holding Co. Inc., Charles M. Garber Sr. owned 68% and his brother Kenneth R. Garber Sr. owned 19%. In 1996 the corporation underwent a “D” reorganization that reduced Charles’ ownership to 19% and increased Kenneth’s to 65%. In 1998 Kenneth sold his shares of the stock to Charles, giving him a total of 84%. On its 1998 tax return following the sale, Garber Industries used an NOL carryforward to offset current income. The IRS objected on the grounds that the NOL should be reduced pursuant to section 382 because of the deemed ownership change.

Result. For the IRS. Section 382 defines an ownership change as a more than 50% increase in ownership by 5% owners during a three-year period. (A 5% owner is an individual who owns at least 5% of the corporation’s stock either directly or indirectly.)

In determining ownership, section 382 requires the use of the section 318 stock attribution rules, under which a person is deemed to own the stock of his or her family members. Siblings are not considered family, but parents, children and grandchildren are. Section 382 modifies these family attribution rules to treat all family members as one shareholder rather than separate shareholders. Garber Industries Holding Co. argued that although siblings are not related under code section 318(a)(1), they should be treated as a single shareholder headed by their parents or grandparents. The IRS argued that since neither the parents nor grandparents of the taxpayers were alive, the brothers were not one family.

The Tax Court first had to decide whether the code language was ambiguous: It found it sufficiently ambiguous to support the positions of both the taxpayers and the IRS. It turned, therefore, to the legislative history to reach its decision.

Based on that review and prior law, the Tax Court rejected the arguments of both parties. It said the taxpayers’ argument would result in a family that consisted not only of parents, children and grandchildren but also aunts, uncles and cousins—and clearly Congress could not have intended this result. The court rejected the IRS’s argument on the grounds it would make the answer solely dependent on the life or death of the parents and grandparents. This also could not have been Congress’s intent.

Based on its analysis of the code language and the evolution of section 382, the Tax Court concluded the rules applied only to living shareholders. A determination of a family must start with an actual shareholder. To these actual shareholders is added stock owned by their parents, children and grandchildren. As Charles and Kenneth were neither children nor grandchildren of a living shareholder, they did not constitute a family. CPAs should be aware that the decision in this case clarifies the definition of an ownership change and when section 382 will limit the use of NOL carryforwards.

Garber Industries Holding Co. v. Commissioner, 124 TC no. 1.

Prepared by E dward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

In the Davis case, Mr. Davis’s trust agreement required that all income of the trust be distributed to his widow and said she could invade the trust principal if the income was insufficient to maintain her health, support and maintenance. Although Mrs. Davis was the trustee and the one who could determine whether the trust income was insufficient, the IRS concluded she did not have the necessary right to have the principal distributed to her. Therefore, the life interest did not qualify for the marital deduction.

Result. For the IRS. The Ninth Circuit determined the terms of the trust were unambiguous: Mr. Davis had left to his widow “an interest limited to the amount of income proper for her health, education, or support, maintenance, comfort and welfare in accordance with her accustomed manner of living;” she, therefore, did not have complete control of the trust income. Consequently, the life estate left to Mrs. Davis did not qualify for the marital deduction.

Estate planners should take care that qualified terminable interests designed to qualify for the marital deduction carefully duplicate the requirements of IRC section 2056(b)(5) and (7) and regulations section 2056(b)-5. Departures from the very specific requirements of these provisions may result in the loss of the marital deduction.

Davis v. Commissioner, 95 AFTR 2d 2005-667, 01/24/2005 (CA-9).

Prepared by Do-Jin Jung, PhD, CMA, CFM, assistant professor of accounting, and Darlene Pulliam, CPA, PhD, professor of accounting, both of West Texas A&M University, Canyon.

In order for payments to qualify as alimony, certain requirements must be met. The payments must be in cash, and pursuant to a divorce, separation or written agreement between the spouses; they must terminate at the death of the recipient; and they must not be designated as something other than alimony in the agreement. In addition, the parties must be living apart when the payments are made. The Tax Court recently issued a ruling that specifically addressed the written-separation-agreement portion of the definition.

Ms. Dato married Mr. Nodurft in 1993. Unfortunately, it was not a match made in heaven, as they divorced several years later. Prior to the divorce, however, they had entered into a separation agreement that provided, in part,
n They would live separately and apart “for the rest of their natural lives.”

Mr. Nodurft would pay Ms. Dato-Nodurft $1,505 per month in spousal support until their divorce became final.

If Mr. Nodurft failed to make these payments in a timely fashion and his wife had to hire an attorney to enforce the agreement, he agreed to pay the attorney fees.

They would file joint returns for any year in which they were still married and eligible to do so under the tax law if it was financially advantageous to do so. The agreement provided for the division of tax obligations and refunds if and when joint returns were filed.

The case involved the tax year 2000, during which Ms. Dato-Nodurft filed a separate return claiming single tax status and failed to include in her income $18,608 of payments received under the agreement. The IRS assessed the additional amounts due on the return.

Result. For the IRS. Ms. Dato-Nodurft contended that because she and Mr. Nodurft were not legally separated during tax year 2000, the payments were not alimony. Further, she contended the separation agreement was not legally binding and therefore the payments made under it were not alimony. The Tax Court disagreed with both arguments.

Of Ms. Dato-Nodurft’s first argument, the court said, simply, “We do not agree.” What is interesting is that authoritative support for her position exists even though she didn’t provide it. Regulations section 1.71-1(b)(2)(i), which defines the written separation agreement, says in part “if the wife is divorced or legally separated subsequent to the written separation agreement, payments made under such agreement continue to fall within the provisions of section 71(a)(2).”

In Bogard, 59 TC 97, payments made by a husband to a wife were determined by the Tax Court to be alimony. The court found that the written separation agreement was valid because, although it did not specifically state the two intended to remain separate and apart, they actually had lived apart during the period at issue. This case, however, would not be relevant if a “legal separation” were required for payments to qualify as alimony. A statement of intent to live apart from one’s spouse, if the two were already legally separated, would be quite redundant.

The court concentrated its opinion on Ms. Dato-Nodurft’s second argument, which was that the payments were not alimony since the agreement was not legally enforceable. She offered little evidence of this, and as mentioned above, the regulations clearly state that a written separation agreement does not have to be legally enforceable to qualify under section 71(a)(2). Specifically, regulations section 1.71-1(b)(2)(i) states, “Such payments are includible in the (recipient’s) gross income whether or not the agreement is a legally enforceable instrument.” This portion of the regulation has been supported on judicial review.

Both the Tax Court and the Seventh Circuit Court of Appeals had ruled in an earlier case, Richardson v. Commissioner (125 F3d 551, 9/12/1997), that even though a state court had found a written separation agreement invalid and unconscionable, it was still valid. Although the agreement was very unfair to Ms. Richardson, she had accepted money from her husband for her separate maintenance and support and knew that it was being paid according to the agreement they had signed. For this reason, the payments were considered alimony even though the agreement was deemed invalid under state law.

In its conclusion, the Tax Court reinforced the position that a “legal separation or divorce” was not a prerequisite to the definition of alimony payments under IRC section 71. With respect to the definition of alimony, CPAs should determine whether a written separation agreement exists, but they need not determine whether the agreement is legally enforceable or whether a legal separation or divorce has been granted.

Antoinette J. Dato-Nodurft v. Commissioner, TC Memo 2004-119.

Prepared by Robert L. Severance, CPA, CIA, CFP, lecturer, department of accounting, Texas State University, San Marcos, and Cheryl Metrejean, CPA, PhD, assistant professor of accounting, Georgia Southern University, Statesboro.