Investing in the stock market is probably one of the fastest ways to get rich. However, to be successful, you must understand the tax implications of your investments.
Getting familiar with Section 318 of the IRC is a great starting point because this section defines the rules for constructive ownership of stock and the relationships affected by these rules.
In short, Section 318 indicates that taxpayers can own an asset such as stock indirectly because they’re related to someone who holds that asset directly.
As a result, the IRS can attribute ownership of stock you own to your spouse if they own stock in the same company. This section doesn’t only apply to individual taxpayers, as it affects trusts, estates, and different business entities.
This article will walk you through IRC Section 318 and show how it can affect your taxes.
Table of Contents
The Key Aspects of Constructive Ownership of Stock
Several sections of the Internal Revenue Code offer definitions of stock ownership. Hence, Section 267, Section 958, and Section 318 of the IRC provide rules taxpayers must use to determine stock ownership.
It’s vital to understand that these rules apply to different sections of the IRC. For instance, Section 318 constructive ownership rules affect a broad range of IRC sections that deal with US international tax law and corporate tax law.
When you buy stock, you become its direct owner for tax purposes. However, the IRS recognizes several types of ownership, including indirect or constructive stock ownership.
This type of ownership is based on the taxpayer’s relationship to the stock’s direct owner. Still, it’s important to understand that definitions of constructive ownership of stock from Section 267 and Section 318 don’t apply under the same circumstances.
However, these definitions are similar in that they refer to ownership attributed to a taxpayer due to their relationship with the stock’s direct owner.
The Purpose and Implications of IRC Section 318
The main goal of this section of IRC is to prevent tax evasion through business transactions between related persons or business entities.
The rules set forth in Section 318 only apply to situations where a close relationship exists between the individuals participating in the transaction. Moreover, definitions of relationships in Section 318 apply exclusively to sections of the IRC that explicitly refer to these definitions.
That’s why definitions of related persons or entities you’ll find in Section 267 and Section 318 are used in different contexts.
IRC Section 318 affects a broad range of IRC sections that refer to domestic and international tax regulations.
Controlled Foreign Corporation rules, net operating loss carryovers, and Foreign Investment in Real Property Tax Act are among IRC sections that rely on Section 318. This section also plays a vital role in Foreign-Derived Intangible Income Regime introduced by the TCJA in 2017.
IRC Section 318 Relationship Categories
Married couples, corporations, and trusts are among taxpayers affected by the Section 318 rules. The section specifies six relationship categories to which constructive ownership of stock can apply, so let’s take a look at these categories.
- Partners and Partnerships: The constructive stock ownership rules apply to partners and partnerships equally, so if a partner in a partnership has direct ownership of stock, that stock can be attributed to the partnership. IRC Section 318 treats S corporations and their stakeholders as partners in a partnership.
- Shareholders and Corporations: Section 318 rules stipulate that a relationship between a shareholder and corporation exists if a shareholder owns directly or indirectly over 50% of the corporation’s stock. These ownership attribution rules only apply to C corporations.
- Beneficiaries and Trusts: Attribution rules for trusts and beneficiaries are complex. Generally speaking, if a trust owns stocks directly or indirectly, its beneficiaries are also considered their owners in proportion to their interest in the trust. Section 318 provides several exceptions to situations when stocks belong to the trust’s beneficiaries, although in most cases, both the beneficiary and the trust are considered owners of such stocks.
- Beneficiaries and Estates: The same Section 318 rules apply to estates and partnerships. Hence, stock owned by the estate is attributable to its beneficiaries and the other way around.
- Stock Option Holders: According to this section of the IRC, a person with an option to acquire stock is considered its direct owner.
- Family members: Stocks belonging to spouses, parents, children, or grandchildren of taxpayers who own stock in the same company are subject to constructive ownership of stock rules.
Quick Guide to Family Attribution Rules Under Section 318
The applications of Section 318 to this relationship category can initially seem simple. The rule states that an individual who owns stock in the same company as their immediate family members is considered the stock’s indirect owner.
For example, if you and your spouse each own 50 shares in a company, Section 318 allows the IRS to attribute your spouse’s shares to you and vice versa. The situation gets more complex if multiple family members own stock in the same company.
Provided that both spouses and their biological child own the same number of shares in a company, the IRS can attribute shares owned by the child and the mother to the father, while the father’s shares can be attributed to the mother.
However, the child’s shares cannot be attributed to both parents because Section 318 doesn’t allow double attribution.
Shares owned by legally adopted children are attributable to their parents, but attribution cannot take place between stepparents and step-children or step-grandparents. Shares owned by grandchildren are attributable to their grandparents, but attribution cannot go the other way.
Family attribution rules defined in Section 318 permit multiple family members to control a corporation simultaneously.
One or more family members can be deemed corporation owners because constructive ownership of stock rules allows them to control more stocks than they actually own.
IRC Section 318 Exemptions
Attribution of stock ownership under Section 318 applies to all married couples until the court issues the final divorce decree.
Couples who own stock in the same corporation are subject to Section 318 rules even if separated under an interlocutory divorce decree until their marriage is terminated.
Family attribution can only occur between two US residents, as non-US residents are excluded from Section 318. This section prohibits stock attribution between siblings, uncles, nieces, and cousins.
As a result, if both spouses and their children own shares in a company, shares owned by one child cannot be attributed to the other.
This section also prevents the attribution of shares between great-grandchildren and great-grandparents. IRC Section 302 Distributions in Redemption of Stock allows shareholders to sever ties from a corporation and waive Section 318 family attribution of stock.
Instead of reporting dividends, shareholders can report capital gains after redeeming their stock and avoid further attribution of stocks owned by their family members.
Frequently Asked Questions
Section 318 doesn’t contain the definition of a stock purchase because it relies on the definition provided in IRC Section 338.
Relationship categories defined under Section 318 use upward and downward attribution methods. Upward attribution involves constructive ownership of stock passed from an entity, such as a corporation or trust to the shareholders or beneficiaries.
Downward attribution indicates that a partner in a partnership is a constructive owner of stock owned by other partners.
Taxpayers must pay taxes for all stocks attributed to them through Section 318 rules. Your tax liability will depend on the number of stocks the IRS attributes to you, how long you or your family members hold these stocks, and other factors.
Indirect stock ownership rules outlined in IRC Section 318 prevent taxpayers who own stocks in controlled foreign corporations from avoiding taxation by dividing stocks among family members.
The Role of Section 318 in Understanding the Corporate Tax
It’s not unusual for newcomers to the stock market to experience a steep learning curve. Not being familiar with Section 318 might make your learning curve even steeper and ultimately affect how much you owe to the IRS at the end of the year.
In its simplest form, this IRC section indicates that you’re deemed an indirect owner of all stocks you and your family members own in a company. As a result, these stocks will be attributed to you, and you’ll have to pay taxes for more stocks than you own.
Section 318 is vital to understanding domestic and international US corporate laws and how buying shares in business entities that operate on foreign or domestic markets can affect federal taxes.
Consulting a tax advisor or a corporate lawyer before acquiring stock holdings is arguably the best way to avoid attribution of constructive ownership of stock and its legal and tax implications.
Author:
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.
