Related Party Transactions – In General
To avoid the manipulation of tax consequences to which transactions between certain related[i] taxpayers may be susceptible, the IRS and the Courts generally require that such transactions be closely scrutinized to ensure that the form of the transaction reflects its underlying economic reality,[ii] and that the tax consequences arising therefrom are consistent with those arising from transactions between unrelated parties dealing at arm’s length with one another.[iii]
Similarly, the Code and the regulations promulgated thereunder have long recognized that a taxpayer who engages in certain transactions with another party should be denied a particular tax benefit that would otherwise be realized from the transaction if the taxpayer and the other party bear a certain relationship to one another and if the sought-after tax benefit is inconsistent with the economic consequences of the transaction.
Then there are those circumstances to which neither the Code and the regulations, nor the IRS and the courts, have spoken clearly or with a degree of specificity on which taxpayers may rely. Among these are transactions – including bona fide arm’s length transactions – that overlap the two categories set forth above, including one that I recently encountered and that is the subject of this post.[iv] In those cases, one must consider the tax policies implicated by the transaction in order to ascertain the correct tax consequences.
Before delving into the issue referenced in the preceding paragraph, it probably behooves us to briefly review some of the related party[v] scenarios alluded to above and the applicable tax rules.
Substance Over Form
The IRS and the courts have long recognized that transactions between a closely held business and its owners should be subject to rigid scrutiny because they are particularly susceptible to a finding that a transfer of funds by the business to an owner was intended as something other than what was reported by the parties for tax purposes. It may even be the case that the transfer was not a bona fide business transfer.
Depending on the facts and circumstances, for example: a non-interest-bearing “demand loan” to an owner may represent a disguised distribution;[vi] a non-pro rata capital contribution or the bargain element of a below-market sale of property to a business may be treated as a gift to other owners;[vii] a sale between related business entities at a price that reflects a premium or discount may be an attempt to shift tax consequences or to take advantage of certain tax attributes.
In these and other related party situations, the IRS will sift through the facts to determine the true nature of the transfer and, if appropriate, may recharacterize the transaction and make whatever adjustments are necessary to prevent the improper avoidance of tax.
Bona Fide Transactions
Of course, there are plenty of situations in which a taxpayer will sell property to a related taxpayer on arm’s-length terms, including a price that reflects an exchange of fair market value.
However, a bona fide business transaction between related parties does not negate the fact of their relationship, and it is that relationship – even in the absence of proof that the parties engaged in the transaction, or structured it in such a way, to improperly reduce taxes – that triggers the application of certain statutory rules of which related parties and their advisers must be aware lest they be blindsided by an unexpected tax liability.
Loss of Installment Reporting
For example, if a taxpayer sells real property to a related purchaser in exchange for a series of deferred payments – whether pursuant to a schedule set forth in the purchase and sale agreement or pursuant to a promissory note – the taxpayer may not be entitled to report the gain from the sale under the installment method[viii] to the extent such gain is attributable to depreciable property (such as a building).[ix]
In that case, all payments to be received under the agreement or note will be treated as received, and included in taxpayer’s income, for the year of the sale, unless the taxpayer can establish that the sale did not have tax avoidance as one of its principal purposes.[x] Any gain that is attributable to the underlying land (which is not depreciable) may still be reported on the installment method, subject to one exception.
If a taxpayer (the original seller) sells property to a related person and, before the second anniversary of the first sale, and before the selling taxpayer receives all the installment payments with respect to such sale, the related buyer disposes of the property, then the amount realized at the time of the second sale will generally be treated as having been received at that time by the taxpayer (the original seller, who may be viewed as part of single economic unit with the buyer), thereby accelerating recognition of the otherwise deferred gain notwithstanding that the taxpayer itself did not receive all the payments to which it was entitled.[xi]
Where the sale of property between related persons results in the realization of a loss by the seller, the deduction to which the seller would otherwise have been entitled in the year of the sale in respect of the loss will generally be disallowed,[xii] even where the transaction is undertaken on arm’s length terms.[xiii]
Why? Because the sale of property occurs between related persons who may be viewed as a single economic unit, the unit as such still has the potential to avoid a loss with respect to the property so long as it owns the property.
Thus, it follows that if the related buyer subsequently sells the property to an unrelated person at a gain, such gain will be recognized only to the extent that it exceeds the previously disallowed loss.[xiv]
Loss of Tax Deferral in Like-Kind Exchange
Even an otherwise tax-free exchange[xv] may be adversely impacted where the parties to the transaction are related.
If a taxpayer exchanges property with a related person in an otherwise qualifying tax-deferred like-kind exchange, based on the principle that the parties represent a single economic unit, the taxpayer may nevertheless be forced into recognizing the otherwise deferrable gain if the related person disposes of the property exchanged within two years of the original transaction.[xvi]
Loss of Capital Gain Treatment
The Code provides that in a sale of property between “related persons,” any gain recognized by the transferor shall be treated as ordinary income – taxable in the case of an individual at a maximum federal rate of 37 percent[xvii] – if such property is depreciable[xviii] in the hands of the transferee.[xix]
By “converting” into ordinary income what would otherwise have been treated as long term capital gain for the individual taxpayer, taxable at a maximum federal rate of 20 percent,[xx] the Code prevents the taxpayer from offsetting their ordinary income from a property, or from a business that uses the property, with depreciation deductions based upon the purchase price for the property[xxi] and then recapturing the benefit of such deductions as capital gain[xxii] when the property is sold to a related taxpayer who may then repeat the cost-recovery income-reducing process.[xxiii]
What About This?
Which brings us to the issue to which I referred earlier. The transaction was conducted at arm’s length, so the application of a substance-over-form analysis to determine the “proper” tax outcome would have been inappropriate. Moreover, neither the Code nor the Regulations provided a clear answer to the question presented.
Specifically, a one-third member of a three-member LLC – that owned a building and was treated as a partnership for tax purposes – sold their LLC membership interest to a business entity which was a “controlled entity” with respect to the selling member – a related person.[xxiv]
The sale of a partnership interest is generally treated as the sale of a capital asset.[xxv] Thus, the gain from the sale is treated as capital gain except to the extent it is attributable to so-called “hot assets” – such as ordinary income depreciation recapture – in which case that portion of the gain will be treated as ordinary income.[xxvi]
The related purchaser’s initial basis in the membership interest was equal to the amount paid for the interest – a cost basis.[xxvii] The seller’s capital account, which was attributable to their membership interest, carried over to the related purchaser.[xxviii] Without more, the LLC’s basis for its assets would not change as a result of the sale.[xxix]
However, there was more. The LLC had previously made an election[xxx] to adjust the basis of the LLC’s property (the “inside basis”) upon the sale of a membership interest.[xxxi] As a result of this outstanding election,[xxxii] an adjustment was made to the basis of the LLC’s property with respect to the related purchaser.[xxxiii]
The Section 754 Election
Before going any further, and in order to appreciate the issue presented, a simplified description of the partnership basis adjustment[xxxiv] is in order.
Assume the LLC owns real property that has been fully depreciated; in other words, its basis for the property is zero for all intents and purposes. On the facts set forth above, the selling member sells their membership interest to the purchaser for a fair market value price – say, $100, which we’ll assume is equal to one-third of the value of the LLC’s property.
If the LLC were to sell the property shortly thereafter, one-third of the gain (i.e., $100) would be allocated to the purchaser notwithstanding that they have not realized any economic gain; after all, the purchaser has just acquired their interest for $100.
To avoid this outcome, the Code permits a tax partnership, like the LLC, to adjust its basis for its property but only for the benefit of the buyer. In general, the amount of the adjustment is equal to the excess of what the purchaser paid to acquire the membership interest ($100) over their “share” of the LLC’s inside basis for its property (zero) – an adjustment of $100.
The amount of the purchaser’s share of the partnership’s gain from the sale of the property ($100) would be reduced by the amount of this basis adjustment ($100), thereby eliminating the purchaser’s gain from the sale.
In the absence of a sale by the LLC of the property, the amount of the basis adjustment is added to the purchaser’s share of the LLC’s depreciation deductions,[xxxv] thereby enabling the purchaser to offset more ordinary income.
We saw earlier that the seller’s gain from the sale of real property to a related person may be converted into ordinary income if the property was depreciable in the hands of the purchase.
Instead of a sale of real property, we have a sale by a member/partner of their interest in an LLC/partnership to a related person who will enjoy the benefit of depreciation deductions attributable to the special basis adjustment described above.
The “economics” are similar to those of a direct sale of depreciable property between related persons, but do the circumstances warrant ordinary income treatment for the seller?
There does not appear to be any judicial or administrative authority directly on point,[xxxvi] but let’s briefly consider some of what’s out there.
For example, the IRS has ruled that the sale by a married couple of their interests in a wholly owned partnership to their wholly owned corporation would be treated as a sale of the partnership’s depreciable property and, thus, the gain therefrom should be treated as ordinary income.[xxxvii]
The IRS has also ruled[xxxviii] that the sale by members of 100 percent of an LLC/partnership’s membership interests to one of the members or to an unrelated non-member should be treated as a purchase of the LLC’s property by the buyer, though the consequences to the sellers would be determined according to the rules applicable to the sale of a partnership interest, as opposed to a sale of the underlying partnership property.[xxxix]
The above ruling does not address the consequences of a sale to a related buyer.
In another ruling[xl] involving the sale of a partnership interest to a related buyer, the IRS held that because the interest sold had “a life of potentially indefinite duration, the partnership interest is not subject to the allowance for depreciation . . . [a]ccordingly, Section 1239 of the Code will not operate to cause any portion of the gain recognized” by the seller to be ordinary income. The ruling made no mention of the election for the adjustment to inside basis.
Based on the foregoing published and private rulings, it appears that the sale of less than all of an LLC’s membership interests to a related buyer will be respected as just that – a sale of membership interests that will not trigger the conversion of gain into ordinary income.
However, the sale of all the interests to a related person should trigger the application of the conversion rule, assuming the underlying LLC property will be depreciable in the hands of the related buyer.
The fact that the LLC has made or will timely make an election for the special adjustment to its inside basis for the benefit of the related buyer probably does not fit neatly into either of these scenarios; in fact, the absence or presence of an election in the second scenario (a sale of all the membership interests) appears irrelevant.
Moreover, the fact that an election is required to generate the depreciable inside basis adjustment for the related buyer of less than all of the LLC’s membership interests may remove the sale of the interests from the reach of the conversion rule, especially where the decision to make the election may reside with an unrelated party.
That said, should the result be different where the other, non-selling members of the LLC are related to the seller and/or the buyer? That’s a closer call but it remains to be seen whether the IRS is willing to extend the reach of the conversion rule to these scenarios.
You May Not Choose Your Related Parties, But You Can Plan
The foregoing describes only some of the pitfalls of which a seller of property must be aware when dealing with a related party buyer. Any sale that may involve a related party should be examined closely to take these and other tax consequences into account. Once the tax issues have been identified, the taxpayer can plan accordingly.
A taxpayer should never be surprised when they are transacting with a related person. This warning applies most strongly to the owners of a closely held business and its affiliates, who are especially susceptible to engaging in such a transaction. They should know that the IRS will subject the transaction to close scrutiny.
The IRS will examine the transaction to ensure that it reflects a bona fide economic arrangement – in other words, that the related parties are dealing at arm’s length with one another and are not trying to achieve an improper tax result by manipulating the terms of the arrangement.
In other situations, such as the those described in this post, there are statutory and regulatory requirements and limitations of which the taxpayer must be aware when dealing with a related person. The disallowance or suspension of a loss, the denial of installment reporting, the conversion of capital gain into ordinary income – all these and more await the uninformed taxpayer.
It is imperative that the taxpayer consult with their advisers prior to undertaking any transaction with any person with which they have some relationship. The adviser should be able to determine whether the relationship is among those that the IRS views as worthy of closer look. The adviser should also be able to inform the taxpayer whether the relationship comes within any of the applicable anti-abuse or other special rules prescribed by the Code or the Regulations.
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[i] Whether parties are related to one another will depend upon the circumstances under consideration. In some cases, the parties to a transaction are treated as related to one another because they satisfy a prescribed set of criteria; for example, based upon family relationship, voting control, overlapping ownership, etc. In others, the “reality of control” is the decisive factor in finding the relationship. See, e.g., IRC Sec. 482.
[ii] A substance over form analysis. For example, does the arrangement reflect an equity investment or a loan?
[iii] IRC Sec. 482. The purpose of IRC Sec. 482 is to ensure that taxpayers clearly reflect income attributable to “controlled transactions” and to prevent the avoidance of taxes with respect to such transactions. Section 482 places a “controlled” taxpayer on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer.
[iv] “X Ո Y Ո Z” for fans of Venn diagrams.
[v] For purposes of this post, we are assuming the existence of the “relationship” that triggers application of the rules discussed. That said, it is imperative that one review the definition of “related” person found in each of the rules discussed – they are not identical. Also be mindful of attribution rules that create a relationship where ostensibly none is evident.
[vi] Especially where the limitations period (6 years in New York) for demanding repayment expires, though it may be possible to revive a stale claim under certain conditions.
[vii] But see Reg. Sec. 25.2512-8 re a sale, exchange, or other transfer of property made in the ordinary course of business; i.e., a transaction which is bona fide, at arm’s length, and free from any donative intent. In other words, there may have been a reasonably good business reasons for a below market transfer.
[viii] IRC Sec. 453.
[ix] IRC Sec. 453(g).
[x] IRC Sec. 453(g)(2).
[xi] IRC Sec. 453(e).
[xii] IRC Sec. 267(a)(1). An important exception to the loss disallowance rule involves the complete liquidation of a corporation, in which case the corporation and its shareholders may recognize their respective losses from the liquidating distribution.
[xiii] The fact that related parties could manipulate the tax consequences by varying the sale price is one reason for disallowing the loss.
[xiv] IRC Sec. 267(d).
[xv] IRC Sec. 1031(a).
[xvi] IRC Sec. 1031(f).
[xvii] As compared to a 20% federal rate for long-term capital gain.
These rules are less significant for C corporations, all the income of which is taxed at a flat federal rate of 21%. Of course, if the corporation has capital loss carryovers, the distinction between ordinary income and capital gain will still be important.
[xviii] IRC Sec. 167. Or amortizable. IRC Sec. 197(f)(7).
[xix] IRC Sec. 1239(a).
[xx] IRC Sec. 1001, Sec. 1222, Sec. 1(h).
[xxi] The cost basis under IRC Sec. 1012.
[xxii] It’s important to note that IRC Sec. 1239 is most relevant to real property. Because such property is depreciated on a straight-line basis, any recaptured depreciation is not treated as ordinary income, though it is subject to tax at the rate of 25%.
In the case of personal property, the recaptured depreciation is treated as ordinary income under IRC Sec. 1245, and such property is not likely to have appreciated in the way that real property typically does, so capital gain treatment is usually irrelevant.
[xxiii] See also IRC Sec. 707(b)(2), which provides, in the case of a sale of property between a partnership and a person owning more than 50 percent of the capital or profit interests in the partnership, or between two commonly controlled partnerships, that any gain recognized shall be treated as ordinary income if the property is other than a capital asset.
[xxiv] Within the meaning of IRC Sec. 1239(b) and Sec. 1239(c). For example, a corporation more than 50% of the value of the outstanding stock of which is owned directly or indirectly by the person in question.
[xxv] IRC Sec. 741.
[xxvi] IRC Sec. 751.
[xxvii] IRC Sec. 1012.
[xxviii] Reg. Sec. 1.704-1(b)(2)(iv)(l).
[xxix] IRC Sec. 743(a).
[xxx] IRC Sec. 754.
[xxxi] IRC Sec. 743.
[xxxii] The election is made by the partnership on its tax return for the year in which the transfer occurred. Once made, the election may only be revoked with the consent of the IRS. Reg. Sec. 1.754-1(c).
[xxxiii] Reg. Sec. 1.743-1(j).
[xxxiv] Which is made under IRC Sec. 743.
[xxxv] Reg. Sec. 1.743-1(j)(3) and (4).
[xxxvi] Perhaps for good reason.
[xxxvii] Rev. Rul. 72-172, applying IRC Sec. 1239.
[xxxviii] Rev. Rul. 99-6.
[xxxix] Capital gain under IRC Sec. 741 except to the extent the hot asset rules of IRC Sec. 751 apply.
[xl] PLR 8052086.