Dealing with sales between related persons

Losses on sales or exchanges of property, made directly or indirectly between related parties, are disallowed (Sec. 267(a)). The loss-disallowance rules prevent taxpayers from manipulating recognition of losses for tax purposes when an economic loss has not actually been realized. (The one exception to the rules applies to complete liquidations under Sec. 267(a)(1)). The disallowance rules apply to any sale or exchange, even if the sale is bona fide and the terms are determined on a fair-market basis. These rules have also been applied to involuntary sales.

Defining ‘related party’

Related parties, for purposes of the loss-disallowance rules, include the following relationships (among others) (Sec. 267(b)):

• Family members, who include an individual’s brothers, sisters, spouse, ancestors, and lineal descendants;
• An individual and an S corporation in which the individual owns (directly or indirectly) more than 50% of the outstanding stock value;
• An S corporation and a partnership (including a limited liability company (LLC) taxed as a partnership), if the same persons own more than 50% of both the corporation’s stock value and the capital or profits interest in the partnership;
• Two S corporations or an S corporation and a C corporation, if more than 50% of each corporation’s outstanding stock value is owned by the same persons; and
• An S corporation and the fiduciary of a trust, if more than 50% of the stock value is owned (directly or indirectly) by the trust or grantor of the trust.

Example 1. Loss disallowed on sale between related parties: N Inc., an S corporation, has 100 shares issued and outstanding. M owns 45 shares, and an unrelated person owns 55 shares. M sells 25 shares to his son, O, for $10,000. M’s basis in the shares is $24,000, so he realizes a loss of $14,000. Because the sale is to a related person (a lineal descendant), the loss is disallowed and is not deductible. (If M later disposes of the property to an unrelated party for a gain, the gain may be reduced by M’s loss, as discussed in Example 3, below.)

Sale or exchange between corporation and shareholder

Losses on a sale or exchange are allowed under the related-party rules if the transaction is between the S corporation and a person who owns 50% or less of the value of the outstanding stock. However, indirect ownership must be included when calculating the value of the shareholder’s stock.

Example 2. Loss disallowed on sale between S corporation and more-than-50% shareholder: R owns 55% of the outstanding stock of P Inc., an S corporation. The remaining 45% is owned by an unrelated person. R sold a parcel of land with a basis of $70,000 to P Inc. for its fair market value (FMV) of $62,000. Thus, R realized a loss of $8,000.

Sec. 267 disallows a deduction for losses incurred (directly or indirectly) upon the sale or exchange of property between certain related persons. Because R owns more than 50% of the corporation’s stock, the loss is disallowed and is not deductible. P Inc.’s basis in the land is its cost, $62,000. (If the corporation later disposes of the property to an unrelated party for a gain, the gain may be reduced by R’s loss, as discussed in Example 3, below.)

Variation: If R owned 50% (rather than 55%) of the stock, he could deduct the $8,000 loss (subject to other applicable limitations) because the Sec. 267 loss-disallowance rule applies to shareholders who own more than 50% of the stock.

Gains and losses from related-party transactions are not offset

If several properties are sold in one transaction to a related party, gain or loss must be computed separately for each item. Gains on some of the items cannot offset the losses on the other items. As a result, the gains are recognized and the losses are disallowed even if the items are sold at one time. Case law has strongly established this nonaggregation position, which prevents the circumvention of the loss-disallowance rules through combinations of sales (Rev. Rul. 76-377; Lakeside Irrigation Co., Inc., 128 F.2d 418 (5th Cir. 1942); Morris Investment Corp., 156 F.2d 748 (3d Cir. 1946)).

Reducing gain with disallowed loss on subsequent sale

A disallowed loss on a sale to a related party may reduce the related buyer’s gain on a subsequent sale (Sec. 267(d)). However, this does not benefit the original seller, and if the related buyer subsequently sells the property for a loss, the loss disallowed on the original sale to the related party is never recognized (Regs. Sec. 1.267(d)-1(a)(3)). In the case of a sale between members of a controlled group, which could include one or more S corporations, the loss is deferred until the property is transferred outside the controlled group, rather than disallowed (Sec. 267(f)).

Example 3. Gain on subsequent sale by related party: F owns all the shares of ABC Inc., an S corporation. Several years ago, F sold an asset (with an adjusted basis of $27,500) to ABC for $17,500, resulting in a realized loss of $10,000 to F. The loss, however, was not deductible because of the Sec. 267 related-party rules. ABC’s adjusted basis in the asset was $17,500 when it sold the asset during the current year to an unrelated buyer for $32,500, realizing a $15,000 gain. However, ABC recognizes only a gain of $5,000 from the sale (i.e., the $15,000 realized gain reduced by the $10,000 loss to F that was disallowed in the earlier year under Sec. 267).

Identifying indirect ownership of stock

Indirect ownership occurs when an individual is deemed to own stock actually owned by another person, as in the following situations (Sec. 267(c)):

• Shareholders are deemed to own their proportionate share of stock owned (directly or indirectly) by the corporation;
• An individual is deemed to own the stock owned by certain family members (brothers, sisters, spouse, ancestors, and lineal descendants); and
• An individual who is a member of a partnership (including an LLC taxed as a partnership) will be deemed to own corporate stock owned (directly or indirectly) by another partner in the same partnership if the individual also directly owns stock in the same corporation.

Stock owned indirectly through a family member or a partner cannot be reattributed to someone related to the indirect owner. Stock owned directly by an individual can be owned constructively by multiple members of their family. Stock owned indirectly through a corporation, partnership, or trust can be attributed to another individual (Sec. 267(c) (5); Regs. Sec. 1.267(c)-1).

Example 4. Indirect ownership of S stock owned by family members: P owns 26% of the outstanding stock of E Inc., an S corporation. His son, R, and his daughter, Q, each own 12.5% of the stock. The remaining 49% is owned by an unrelated person. During the year, P sold a parcel of land to E Inc. for its FMV of $62,000; his basis in the land was $70,000. P thus realized a loss of $8,000.

Sec. 267 disallows a deduction for losses incurred (directly or indirectly) upon the sale or exchange of property between certain related persons. Since the stock ownership of family members is considered indirect stock ownership under Sec. 267(c), P must include the stock owned by his children to determine whether the Sec. 267 loss limitations apply. Thus, he is considered to own 51% of the stock of E Inc. Because he is considered to own more than 50% of the corporation’s stock, the loss is disallowed and is not deductible. E Inc.’s basis in the land is its cost, $62,000. (If E later disposes of the property to an unrelated party for a gain, the gain may be reduced by P’s loss — see Example 3.)

Variation: Assume now that P owns 25% (instead of 26%) of the stock. Under Sec. 267(b)(2), an individual must own more than 50% of the stock for the loss limitation to apply. P can therefore deduct the loss, since his direct and indirect ownership of E Inc. stock is exactly (not more than) 50%. E’s basis in the land is its cost of $62,000.

Example 5. Determining if taxpayers are related parties under Sec. 267: A, B (A’s brother), C, D, and G Corp. each directly own 20% of the stock of F Corp. C and E (D’s wife) each directly own 50% of the stock of G Corp. B and D each directly own a 5% interest in PTR Partnership.

Constructive ownership of the F Corp. stock is attributed to the shareholders as follows:

1. A’s and B’s directly owned stock is attributed to each other because they are family members (brothers). The attributed stock cannot be reattributed to anyone else.
2. B’s and D’s directly owned stock is attributed to each other because they are partners in the same partnership (PTR Partnership). The attributed stock cannot be reattributed to another person. B’s direct stock is attributed to D; however, B’s indirect stock in F Corp. that was attributed from A is not reattributed to D.
3. G Corp.’s directly owned stock is attributed to its shareholders, C and E. As a result, they each own indirectly 10% of F Corp. This stock, constructively owned by C and E, can be reattributed to other individuals. Therefore, the stock indirectly owned by E through G Corp. is constructively owned by D because they are married.

To summarize, the (direct and indirect) ownership of F Corp. is as shown in the table “Direct and Indirect Ownership of F Corp.”

B is the only F Corp. shareholder who is considered to own, directly or indirectly, more than 50% of its stock. Thus, B is related to the corporation under the Sec. 267 rules. None of F Corp.’s other shareholders are related to the corporation because none of their ownership interests exceed 50%.

If G Corp. were a partnership instead of a corporation, E’s 10% stock ownership in F Corp. through G Corp. would still be reattributed to D.

Making like-kind exchanges between related parties

Generally, taxpayers do not recognize gain or loss when real property held for productive use in a trade or business is exchanged for like-kind property. However, Sec. 1031(f ) places special limitations on these nonrecognition provisions when the transaction involves related parties. If property received in a like-kind exchange between related persons is disposed of within two years after the date of the last transfer in the exchange, any gain or loss not recognized on the original exchange must be recognized upon the property’s disposition. “Related party” is defined by reference to Sec. 267(b). A disposition during the two-year period will not trigger immediate gain recognition if it is (Sec. 1031(f)(2)):

• After the death of the taxpayer or the related person;
• In a compulsory or involuntary conversion, as long as the exchange occurred before the threat or imminence of the conversion; or
• Established to the satisfaction of the IRS that neither the exchange nor the disposition had tax avoidance as one of its principal purposes.

Example 6. Losing the gain deferral when like-kind property is sold within two years after the exchange: P owned a tract of land with an FMV of $100,000 and a basis of $70,000. P is the sole shareholder of E Corp., which owned a similar tract with an FMV of $100,000 and a basis of $90,000. On Oct. 1 of the prior year, P exchanged his land for E Corp.’s land.

Under the Sec. 1031 like-kind exchange rules, P’s basis in his new land is $70,000, and E Corp.’s basis in its new land is $90,000. E Corp. sold its new land on Oct. 1 of the current year.

Since E Corp. sold the land before two years had elapsed, Sec. 1031 no longer applies. As of the date of the sale, both P and E Corp. must recognize gain on the prior like-kind exchange. P has a gain of $30,000, the excess of the FMV of the asset received ($100,000) over the adjusted basis of the asset surrendered in the exchange ($70,000). E Corp. has a gain of $10,000 ($100,000 FMV of asset received, less the $90,000 basis of the asset given up). 

Variation: Assume instead that P died in the current year and the property he received in the exchange was sold. The sale of P’s land would not trigger recognition of the gain realized on the like-kind exchange because the sale occurred on account of (after) his death.

This Sec. 1031 related-party rule applies to both parties to the exchange. Furthermore, deferral of income under Sec. 1031 does not apply to any exchange that is part of a transaction or series of transactions structured to avoid the purposes of the related-party rule (Sec. 1031(f)(4)). For example, if a taxpayer, under a prearranged plan, transfers property to an unrelated party who then exchanges the property with a party related to the taxpayer within two years of the previous transfer, the exchange will not qualify for nonrecognition treatment under Sec. 1031 (Rev. Rul. 2002-83).

Contributor

Shaun M. Hunley, J.D., LL.M., is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org.

This case study has been adapted from Checkpoint Tax Planning and Advisory Guide‘s S Corporations topic. Published by Thomson Reuters, Frisco, Texas, 2024 (800-431-9025; tax.thomsonreuters.com).