Business Tax Preparation · Analysis of financial records

Related party activity

Related party rules do not ask whether a transaction was fair. They ask who was on the other side, and then they disallow, defer or recharacterise without regard to how arm’s length the price was. That is why they are unforgiving: a perfectly priced sale between a shareholder and their company can still produce a loss nobody ever deducts.

The rule

Losses first. no deduction is allowed for any loss from a sale or exchange of property, directly or indirectly, between persons in any of the listed relationships — the one carve-out being a loss of the distributing corporation or the distributee on a distribution in complete liquidation^TY2026 (IRC § 267(a)(1)). Note the words directly or indirectly: routing the sale through a third party does not save it.

Then timing. where the payee’s method of accounting means the amount is not includible until paid, and the payer and payee are related at the close of the payer’s year, the payer’s deduction is deferred to the year the amount is includible in the payee’s income^TY2026 (IRC § 267(a)(2)). This is the rule that catches an accrual basis company accruing a bonus or interest to a cash basis owner.

Who is related. the listed relationships include family members; an individual and a corporation more than 50 percent of which that individual owns; two corporations in the same controlled group; a range of grantor, fiduciary and beneficiary combinations; a person and a controlled IRC § 501 organization; a corporation and a partnership more than 50 percent of each owned by the same persons; and various S and C corporation pairings on the same 50 percent test^TY2026 (IRC § 267(b)), with ownership tested through stock owned by a corporation, partnership, estate or trust is treated as owned proportionately by its owners; an individual is treated as owning stock owned by family; and an individual owning stock otherwise than by family attribution is treated as owning stock owned by a partner^TY2026 (IRC § 267(c)). The family definition is narrower than intuition suggests: the family of an individual includes only brothers and sisters, whether by the whole or the half blood, the spouse, ancestors and lineal descendants — so a sibling and a half-sibling are both in, and a step-parent, an in-law, an aunt, an uncle, a niece, a nephew and a cousin are all out^TY2026 (IRC § 267(c)(4)).

What happens to the disallowed loss. where a loss was disallowed on a sale to the taxpayer, the taxpayer’s later gain on that property is recognised only to the extent it exceeds the disallowed loss allocable to it — relief available to the transferee alone, and lost entirely if the property is never sold at a gain^TY2026 (IRC § 267(d)(1)). It does not carry over to the seller and it does not sit in suspense. It goes to the buyer, as a shield against later gain, and only against gain on that property.

Partnerships have their own version. the same loss disallowance applies between a partnership and a person owning more than 50 percent of its capital or profits interest, and between two partnerships more than 50 percent of each owned by the same persons — with IRC § 267(d) applied to a later sale as if the loss had been disallowed under § 267(a)(1)^TY2026 (IRC § 707(b)(1)), and gain is caught too: gain on a sale between those same parties is ordinary income where the property is, in the transferee’s hands, other than a capital asset^TY2026 (IRC § 707(b)(2)).

Gain on depreciable property. gain on a sale or exchange of property, directly or indirectly, between related persons is ordinary income if the property is depreciable in the transferee’s hands — so the seller cannot convert capital gain by selling to a controlled entity that will depreciate the asset^TY2026 (IRC § 1239(a)).

Like-kind exchanges. where a taxpayer exchanges property with a related person and either of them disposes of the property received within 2 years of the last transfer, nonrecognition is denied to the taxpayer and the gain or loss is taken into account as of the date of that disposition^TY2026 (IRC § 1031(f)(1)), subject to dispositions after the earlier of the death of the taxpayer or of the related person, compulsory or involuntary conversions where the exchange preceded the threat, and dispositions neither of which had tax avoidance as a principal purpose, are not counted — and the section does not apply at all to an exchange structured to avoid the subsection^TY2026 (IRC § 1031(f)(2) and (4)).

Below-market loans. on a below-market gift loan or demand loan the forgone interest is treated as transferred from the lender to the borrower and retransferred by the borrower to the lender as interest, deemed to happen on the last day of the calendar year^TY2026 (IRC § 7872(a)). And on the records side, credit balances in accounts receivable may represent deposits, advance payments or overpayments that are additional income or unrecorded sales^TY2026 — a related party balance in receivables is one of the items IRM 4.10.3.10.4 directs an examiner to test for adequate stated interest and original issue discount.

Current figures

How it works in practice

Test the relationship before testing the price. None of these provisions has a fairness exception. A sale at a professionally appraised value between a father and daughter is caught by § 267(a)(1) exactly as a sale at a contrived price would be, and the taxpayer’s evidence that the terms were commercial is beside the point.

Learn the family list by what it excludes. Brothers and sisters of the whole or half blood, the spouse, ancestors and lineal descendants — and nothing else. Aunts, uncles, nieces, nephews, cousins, in-laws and step-relations are all outside § 267(c)(4). Candidates lose marks in both directions: assuming a nephew is related, and assuming a half-brother is not.

The disallowed loss changes hands. This is the single most misunderstood point. The seller does not defer the loss and cannot use it later; it is gone. What survives is a right in the buyer to reduce a later gain on that same property. If the buyer sells at a loss, or holds forever, or gives the property away, the disallowed loss is never used by anyone.

Watch accrued amounts owed to owners at year end. An accrual method S corporation that accrues interest to its cash basis sole shareholder gets no deduction until the year the shareholder includes it. The pair is related throughout, and the mismatch the matching rule exists to prevent is exactly the one a year-end accrual creates.

Section 1239 defeats the obvious plan. Selling a fully depreciated asset to a controlled company would otherwise convert the seller’s gain into capital gain while giving the buyer a fresh depreciable basis. Section 1239 makes the gain ordinary whenever the property is depreciable in the transferee’s hands, which removes the point of the exercise.

On an exchange, the two-year clock runs on both sides. A disposition by either the taxpayer or the related person within two years of the last transfer unwinds the nonrecognition, and the gain is taken into account as of the date of that disposition rather than the original exchange. Death, compulsory conversion and a no-tax-avoidance disposition are the escapes.

Scenarios

Traps

How this has changed

The architecture here is old and has moved mainly at the edges. IRC § 267 in something like its present form dates from the 1930s, when the loss disallowance was enacted against sales designed to harvest losses without changing beneficial ownership; the matching rule in § 267(a)(2) was added in 1984 to close the mirror-image mismatch on accrued expenses. The relationships list has been extended several times, most recently to cover S corporation and C corporation pairings under common ownership.

Section 1031(f) arrived in 1989 in response to exchanges in which related parties swapped a high-basis for a low-basis property and the low-basis property was then sold, which extracted the benefit of nonrecognition without the intended continuity. The anti-abuse provision in § 1031(f)(4) was drafted broadly enough to reach structures the two-year rule alone would miss.

The most consequential recent change is not to these provisions at all but to what they now apply to. Since Pub. L. 115-97 confined IRC § 1031 to real property, related-party exchanges of equipment, vehicles and intangibles no longer arise, and the § 1031(f) analysis has narrowed accordingly. Meanwhile bonus depreciation permanent at the full statutory rate makes § 1239 more important, since a related buyer of depreciable property can now recover the whole purchase price immediately — which is precisely the asymmetry § 1239 was written to prevent.

Exam focus

Know the § 267(c)(4) family list exactly, in both directions. It is the most reliably tested item here and the distractors are always the excluded relations.

Distinguish § 267(a)(1) from § 267(a)(2) by their effect: permanent disallowance for losses on sales, deferral to the payee’s year for expenses and interest. Then know that a § 267(a)(1) loss moves to the transferee under § 267(d) and is available only against gain on that property.

For partnerships, remember that § 707(b)(1) applies the same disallowance on a more-than-50-percent capital or profits interest, and § 707(b)(2) makes gain ordinary where the property is not a capital asset in the transferee’s hands.

Keep § 1239 and § 707(b)(2) apart. Section 1239 turns on the property being depreciable in the transferee’s hands; § 707(b)(2) turns on it being other than a capital asset.

For § 1031(f), memorise the two-year period, that a disposition by either party starts it, that the gain is taken into account at the date of the later disposition, and the three exceptions.

Check yourself

1. A taxpayer sells stock at a $40,000 loss to her nephew, and separately sells land at a $25,000 loss to her half-brother. Which losses are disallowed?

Answer: Only the land. IRC § 267(c)(4) defines family as brothers and sisters whether by the whole or half blood, spouse, ancestors and lineal descendants — so a half-brother is squarely within it and the $25,000 loss is disallowed under § 267(a)(1). A nephew is not on the list and is not a related party for this purpose, so the $40,000 stock loss is allowed provided nothing else, such as the wash sale rule, applies. The intuition that a closer-sounding relation is caught and a half-relation is not gets both answers wrong.

2. A father sells equipment with a basis of $60,000 to his daughter for $95,000. She will use it in her business. How is his gain taxed?

Answer: As ordinary income. IRC § 1239(a) treats gain on a sale between related persons as ordinary income where the property is, in the transferee’s hands, of a character subject to the allowance for depreciation — which equipment used in a business is. The character conversion is the whole point: without § 1239 the father would take capital gain while the daughter took a stepped-up depreciable basis. Note that § 1239 has its own definition of related persons in § 1239(b), which is not identical to § 267(b), so the relationship must be tested under the right provision.

3. An accrual basis partnership accrues $30,000 of rent to a partner holding a 60 percent profits interest, who reports on the cash method, and pays it four months after year end. When is the deduction allowed?

Answer: In the year of payment. IRC § 267(a)(2) defers a deduction where the payee’s method means the amount is not includible until paid and the parties are related at the close of the payer’s year. A partner holding more than 50 percent of the profits interest and the partnership are within IRC § 707(b)(1)(A), and § 707(b)(1) provides that partnerships described in subparagraph (B) are treated as § 267(b) persons for § 267(a)(2) purposes. The deduction is not lost — deferred only, to match the partner’s inclusion.

4. Two related companies exchange like-kind real property. Twenty months later one of them is liquidated and the property distributed. What is the consequence?

Answer: The nonrecognition is denied to the taxpayer, and the gain or loss is taken into account as of the date of that disposition rather than the exchange date. IRC § 1031(f)(1) is triggered by a disposition by either party within two years of the last transfer, and a liquidating distribution is a disposition. The exceptions in § 1031(f)(2) do not reach it: nobody has died, it is not a compulsory or involuntary conversion, and a liquidation of a related entity holding property received in a related-party exchange will struggle to establish that neither the exchange nor the disposition had tax avoidance as a principal purpose.

5. Why does IRC § 267(d) give relief to the buyer rather than restoring the loss to the seller?

Answer: Because the object of § 267(a)(1) is to stop a loss being realised on a transaction that does not change the economic position of the related group, while still preventing the same appreciation being taxed twice. Restoring the loss to the seller would defeat the first purpose; giving nothing to anyone would achieve it at the cost of taxing the buyer on gain that merely reverses the seller’s disallowed loss. Attaching the shield to the property in the buyer’s hands does both — and accepts, as the price, that the loss disappears entirely if the buyer never sells at a gain.