In a case that I'm appealing for the taxpayer, Treasury disqualified a C Corporation from the Small Business Credit.  The Corporation is owned by three separate grantor trusts.  The grantors of the three separate trusts are a mother and her two adult sons.  They are also officers of the Corporation.  The Form C-8000KC was prepared listing the individual officers separately from the three trusts.  The three trusts were separately listed as shareholders and the three individuals were separately listed as officers.

Treasury disallowed the small business credit by combining the income allocated to each trust with the Form W-2 compensation paid to each individual officer.  Where the Form W-2 income did not exceed the disqualifying amount of $115,000; when the allocated income was added, the total exceeded the $115,000 disqualifying amount.  The credit was disallowed.

Treasury is asserting that in the case of a grantor trust in which the grantor is taxed on trust income; stock owned directly or indirectly by or for a trust is deemed owned by the grantor.  IRC Section 318(a)(2)((ii) deem the settlor of a trust to be the owner of all or part of the trust property.  Consequently, the settlor must include in computing taxable income and credits those items of income, deduction, and credit which are attributable to that portion of trust property of which he or she is deemed the owner. 

The taxpayer did not apply the attribution rules of IRC Section 318(a)(2)((ii) and kept the individual officers separate from the trust shareholders.  The taxpayer did not attribute the stock owned by the trust as constructively owned by the grantor of the trust who was also an officer. 

Section 36 of the Single Business Tax Act (SBTA) defines "shareholder" in subsection (d) as "a person who owns outstanding stock in a businsss.  An individual is considered as the owner of the stock owned, directly or indirectly, by or for family members as defined by section 318(a)(1) of the internal revenue code."  [MCL 208.36(d)]  For purposes of defining "shareholder", only attribution between members of family as defined in IRC Section 318(a)(1) apply, specifically, spouse, children, grandchildren and parents.

Treasury is using the family attribution rules found in IRC Section 318(a)(1) to import the grantor trust rules from IRC Section 318(a)(2)((ii) to see through the trust to the grantor and hold the individual grantor as the shareholder/officer.

I fail to see how Treasury can make this leap as Section 36(d) limits the constructive ownership rules to only family members.

Any commend would be appreciated.