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FAMILY VALUES: ARE YOU YOUR BROTHER'S RELATIVE?

January 31, 2005

The tax law is full of backhanded tributes to family values -- especially the family value of scheming with your relatives to avoid taxes. These tributes to the ties of kinship take the form of rules delaying, disallowing or altering the results of transactions between relatives.

If you have rules that treat transactions between relatives differently, you have to have rules that say who your relatives are. Your brother? Your spouse? Your sister-in-law's second cousin? It would be a simple matter to have one set of rules for this. That's probably why the tax law has two major sets of rules defining relatives differently for different things, and at least a half-dozen such rules altogether.

It can get complicated, this relative business. Garber Industries Holding Co. lost $680,000 in loss deductions last week because two brothers turned out to be unrelated, under the tax law.

SECTION 382: LOSS TRAFFIC ROADBLOCK

The tax law frowns on the purchase of businesses simply to use their tax loss carryforwards. If a corporation has a taxable loss for a year, it normally can carry that loss back two years to get tax refunds; if the loss doesn't get used up in the carryback, it carries forward for 20 years, or until it offsets income.

While there are many limits to the purchase of companies to use their tax losses, the main barrier nowadays to traffic in tax losses is Section 382. This section limits the use of tax losses in companies that have had an "ownership change" to an interest rate multiplied by the value of the company. For example, a loss corporation purchased for $1 million in January 2005 could use $42,700 losses annually ($1 million x the 4.27% "long-term exempt rate")-- even if it had millions of dollars in loss carryforwards.

An "ownership change" takes place if 50% of the corporation's stock changes hands in a 3-year period. The tax law actually helps families here by treating certain relatives as a single shareholder. Transfers between such relatives don't count in measuring ownership changes.

SORRY, BRO

In April 1998, Kenneth Garber sold all of his shares in GIHC to his brother, Charles. This increased Charles's ownership percentage from 19% to 84% - a 65% shift that would trigger Section 382 if the brothers weren't related. And, under the tax law, they aren't.

Section 382 uses Section 318 to determine who your relatives are. Section 318, for obscure reasons, doesn't count siblings as relatives. The Garbers argued that the way Section 382 uses Section 318, anybody with the same parent is related anyway. The IRS said that the Garbers were right, but only if the parent was still alive; Kenneth and Charles were orphans by 1998.

The Tax Court said the both Garbers and the IRS were wrong - you are related to your parents under Section 382 (dead or alive), but that doesn't make you related to your siblings.

A BAD DEAL

Perhaps most galling for the Garbers is that at the beginning of the three-year Section 382 testing period, Charles owned 68% of the stock. If an intervening reorganization were ignored, Charles's ownership went only from 68% to 84%, a mere 16% change that wouldn't trigger the Section 382 limits. Unfortunately, the reorganization lowered his interest to 19% before he bought Kenneth's shares; Section 382 uses your lowest ownership interest in the testing period to measure ownership changes.

THE MORAL?

Transactions between relatives should always be vetted with your tax advisors, just in case. This is especially true when the deal involves a loss corporation.

Cite: Garber Industries Holding Co., Inc. v. Commissioner, 124 T.C. No. 1.

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