Rev. Rul. 75-524: Option Attribution for Controlled Groups

An Internal Revenue Service (IRS) Revenue Ruling is an official interpretation of the Internal Revenue Code and related statutes. These rulings are published to provide guidance to both taxpayers and IRS personnel, ensuring that the tax law is applied uniformly. Unlike regulations, which have the force of law, a revenue ruling represents the IRS’s conclusion on how the law applies to a specific set of facts. While they are not binding on courts, they carry significant weight and are often relied upon by tax professionals to understand the IRS’s position on complex issues.

The Controlled Group Concept

The Internal Revenue Code establishes the concept of a controlled group of corporations to prevent business owners from splitting a single enterprise into multiple entities to gain duplicate tax advantages. When corporations are determined to be part of a controlled group, they are treated as a single entity for certain tax purposes, forcing the sharing of various tax benefits. The rules primarily apply to two types of controlled groups: the parent-subsidiary group and the brother-sister group.

A parent-subsidiary controlled group exists when one or more chains of corporations are connected through stock ownership with a common parent corporation. A brother-sister controlled group involves two or more corporations where five or fewer individuals, estates, or trusts meet two specific ownership tests.

The first test for a brother-sister group is the 80% total ownership test. This test is met if the same five or fewer individuals own at least 80% of the total combined voting power or total value of shares of each corporation. The second test is the 50% identical ownership test. This test requires that the same five or fewer individuals own more than 50% of the voting power or value of each corporation, but only by taking into account the smallest amount of stock each person owns in any of the corporations. Both tests must be satisfied for the corporations to be classified as a brother-sister controlled group.

The Core Scenario of the Ruling

Revenue Ruling 75-524 presents a scenario involving two corporations, Corporation X and Corporation Y, and two related individuals, a father and his son. The father owns 100% of the single class of stock of Corporation X, and his son owns 100% of the single class of stock of Corporation Y. On the surface, no single person owns stock in both companies.

The ruling introduces a contractual right: the son possesses an unconditional option to acquire all of his father’s stock in Corporation X. This option is exercisable at any time, at the son’s sole discretion. There are no contingencies that must be met before the son can exercise his right to purchase the stock.

The Ruling’s Conclusion on Stock Attribution

The IRS’s conclusion is based on the application of stock attribution rules found in the Internal Revenue Code. These rules are designed to look beyond direct legal ownership to determine who truly controls a corporation by attributing ownership from one person to another. The option attribution rule states that a person who has an option to acquire stock is considered to own that stock.

The IRS determined that the son’s unconditional right to buy the father’s stock in Corporation X was an “option” under this rule. Because the son could become the legal owner at his election, the tax law treats him as the owner for controlled group testing purposes. The father’s actual ownership of Corporation X is disregarded, and that ownership is constructively passed to the son.

With the application of the option attribution rule, the son is now considered to own 100% of Corporation X and 100% of Corporation Y. As a single individual deemed to own 100% of both corporations, this satisfies both the 80% total ownership test and the 50% identical ownership test. Consequently, the IRS concluded that Corporation X and Corporation Y form a brother-sister controlled group.

Tax Consequences of the Ruling’s Determination

The determination that Corporation X and Corporation Y constitute a controlled group carries significant tax consequences. The primary effect is that the two corporations must share certain tax benefits as if they were a single taxpayer. This prevents the enterprise from receiving double the benefits simply because it operates through two separate legal entities.

For example, the accumulated earnings credit, which allows a corporation to accumulate a certain amount of earnings without being subject to the accumulated earnings tax, must be divided among the group members. This single credit is $250,000, but it is reduced to $150,000 for corporations whose principal function is performing services in fields like health, law, or accounting. Similarly, the Section 179 expense deduction, which allows taxpayers to deduct the cost of certain property as an expense when the property is placed in service, is also limited. The group as a whole is subject to one maximum deduction amount, which must be allocated among the members.