Two December Tax Court decisions show the importance of following the form of the law before claiming a dependency exemption for a child following a divorce.
The IRS has a Form 8332 which is used for the custodial parent to release the exemption to the non-custodial parent. Using this form makes it clear that the custodial parent’s release is unequivocal.
In case one, a 2003 arbitration agreement between the parents split the exemptions for their two children. A state court order accepted this agreement. The wife, as custodial parent, was required to release one exemption if the husband was current on child support.
In 2007 the wife did not provide the husband with a Form 8332. The husband claimed the exemption anyway, and attached a copy of the court order, which the wife had signed.
The Tax Court denied the husband the exemption because the state court order was not of the same form as the Form 8332 – the court’s order was conditioned on the husband meeting child-support obligations, whereas the Form 8332 was unconditional.
In the second case, the custodial (wife) parent signed the Form 8332, but claimed the exemption anyway because she thought the court order was improper. The Tax Court denied her the exemption because she had signed the IRS form.
Divorce tax issues can be complicated, and these two cases show that following the proper form can have significant tax consequences for both former spouses.
Q: I have a client who made a gift of stock in an S corporation at the end of 2012 to take advantage of the $5 million gift exemption in case Congress lowered the exclusion to $1 million in 2013. We were able to gift a large amount of stock because the stock has declined in value the past few years. At the date of gift, the stock basis was $20,000 per share. We had a valuation done that determined the fair market value (FMV) to be $12,000 per share. I know the income tax rules say that the donee’s tax basis for a future loss if the stock is sold is $12,000 per share (FMV at date of gift), and the basis for future gain from sale is $20,000 (the donor’s basis). What I’m not sure about is which basis do we use for determining whether future losses are deductible, and which basis do we use for determining whether cash distributions are tax free?
A: Normally when property is transferred by gift the donee takes the same basis as the donor. When gifted property has a basis in excess of FMV, the “split” basis you mention comes into play. This split basis ensures that an unrealized loss cannot be shifted to the donee.
Because the stock in your example has a unrealized loss of $8,000 per share at the date of gift, the donee’s basis is limited to FMV at date of gift. This means the donee has no tax loss unless the stock drops in value after the gift occurs.
But if the stock increases in value, and is later sold for a possible gain, the donee is entitled to use the full $20,000 basis of the donor to determine if a tax gain must be reported. A sale for any amount between $12,000 and $20,000 results in no gain or loss being reported.
Losses of an S corporation may only be deducted if the shareholder has sufficient tax basis in his or her stock. For your scenario, the tax regulations tell us to use the “loss” basis for determining if any losses may be deducted.
Distributions in excess of a shareholder’s tax basis result in gain to the shareholder, as if the stock was exchanged for the distribution. This generally results in recognition of a capital gain by the shareholder.
There is no explicit statement as to which basis you should use for determining whether distributions are taxable. However, the only reason to use any basis for such a transaction is to determine whether a gain from a deemed exchange of stock must be recognized.
Because only gain may be recognized from a distribution, I believe that it is implicit that the gain basis would be used.
James R. Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.