Related Party Transactions
Few individual owners of a closely held business would be surprised if you explained to them that the IRS and the Federal courts generally will subject many transactions between certain “related” persons to heightened scrutiny (a) to ensure that the related persons have not structured a transaction to gain a tax advantage without also having a bona fide business purpose, or (b) to ascertain whether the intended economic consequences of the transaction are consistent with its form and with how it is reported by the parties for tax purposes.
However, those same individuals may be taken aback if you described to them some of the measures that Congress has enacted over the years to prevent related persons from realizing certain tax benefits that Congress has determined would be inappropriate in the context of a transaction between related parties.
Gain Treated as Ordinary
For example, the Code provides that any gain recognized by a transferor in a sale of property, directly or indirectly, to certain persons related to the transferor will be treated as ordinary income – taxable, in the case of an individual transferor, at a maximum federal income tax rate of 37 percent[i] – if such property is depreciable in the hands of the transferee.[ii]
Similarly, in the case of a sale of property, directly or indirectly, between a partnership and a person[iii] owning directly or indirectly more than 50 percent of the capital or profit interests in the partnership, or between two commonly controlled partnerships, any gain recognized by the transferor will be considered ordinary income if the property is other than a capital asset in the hands of the transferee.[iv]
Perhaps a more surprising result to an individual owner of a closely held business would be the disallowance of a taxpayer’s deduction for a loss arising from the taxpayer’s direct or indirect sale of property to a related person.[v]
Unfortunately, it is often the case that only after their tax return has been audited will a taxpayer discover that the long-term capital gain from a sale of property to a related person, as reported on their tax return for an earlier tax year, should have been treated instead as ordinary income; likewise with respect to the disallowance of an earlier claimed loss from their sale of property to a related person.
In many instances, the taxpayer is made aware of the loss disallowance or ordinary income treatment during the preparation of the federal tax return on which the related party transaction in question is being reported. Even then, there is little the taxpayer can do to reverse the unexpected and unwelcome tax result because every taxable year is generally treated as a separate “unit” for tax accounting purposes, meaning the tax consequences of a transaction are determined on the basis of the facts as they exist at the end of the taxable year in which the transaction was completed.
Of course, to avoid the foregoing outcomes a taxpayer should always consult with knowledgeable advisors prior to engaging in any transaction with a related person.
That said, it would also help if the taxpayer, themselves, were better attuned to the risk, which requires an ability to identify a relationship that may trigger application of the above-described tax rules.
In general, the relationships in question fall into two categories: (1) those involving partners and their partnerships,[vi] and (2) those involving all other taxpayers.[vii] Each of these categories is subject to its own set of related party rules (though there is some overlap), which may sometimes generate surprising results, as we will see shortly.
The second category is comprised of thirteen different relationships, with the following being the most commonly encountered in the context of a business (Second Category relationships):[viii]
- Members of a family, which include the taxpayer’s brothers and sisters, spouse, ancestors, and lineal descendants;
- An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual;
- Two corporations which are members of the same controlled group;
- A corporation and a partnership if the same persons own more than 50 percent in value of the outstanding stock of the corporation, and more than 50 percent of the capital interest, or the profits interest, in the partnership;
- An S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation; and
- An S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation.
The first category – that of partner-partnership relationships (First Category relationships)– includes:
- A partnership and a person (not necessarily a partner in the partnership) owning, directly or indirectly, more than 50 percent of the capital interest, or the profits interest, in such partnership; and
- Two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests.
For purposes of determining whether the ownership requirements described above are satisfied – and one of the predicate relationships established – the following rules of constructive ownership are applied:
- In the case of Second Category relationships:
- Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is considered as being owned proportionately by or for its shareholders, partners, or beneficiaries (entity-to-owner attribution);
- An individual is considered as owning the stock owned, directly or indirectly, by or for his family (family attribution);[ix]
- An individual owning (other than through family attribution) any stock in a corporation is considered as owning the stock owned, directly or indirectly, by or for his partner (partner-to-partner attribution); and
- Stock constructively owned by a person by reason of the application of entity-to-owner attribution is (for the purpose of applying any of the above attribution rules) treated as actually owned by such person,[x] but stock constructively owned by an individual by reason of the application of the family attribution or the partner-to-partner attribution rules is not treated as owned by such person for the purpose of again applying either of such rules to make another person the constructive owner of such stock.[xi]
- In the case of First Category partner-partnership relationships, the ownership of a capital or profits interest in a partnership is determined in accordance with the same rules for constructive ownership of stock described above, other than the partner-to-partner attribution rule. The application of these rules contemplate circumstances in which the sale of property between a partnership and one who is not a member of the partnership may nevertheless be subject to the loss disallowance rule.
An Open Question?
An examination of the constructive ownership rules, and especially their application to a “real life” scenario, will sometimes leave me exhausted. What initially seems to be a fairly straightforward exercise may turn into a morass as one first considers the more apparent relationships between the two parties to a transaction and then delves into the various alternative relationships among their respective indirect owners.
As if that weren’t enough, there are times when the recharacterization and disallowance rules themselves are challenging in their own right. For example, Second Category transactional relationships[xii] do not expressly include sales between an individual and a partnership in which loss is realized.
In fact, the only Second Category relationship involving a partnership as a party to a sale is one between a corporation and a partnership where the same persons own more than 50 percent in value of the outstanding stock of the corporation, and more than 50 percent of the capital or profits interest in the partnership.[xiii]
Because the Second Category relationships fail to include partners and partnerships as related persons, it appears on the face of the Code that purchase and sale transactions involving partners and partnerships in which a loss is realized are not within the scope of the loss disallowance rules applicable to transactions involving Second Category relationships.[xiv]
At first blush, this seems reasonable because First Category relationships are dedicated to transactions involving partnerships. In fact, current IRS regulations state that because Second Category relationships do “not include members of a partnership and the partnership as related persons” – a potential First Category relationship[xv] – “transactions between partners and partnerships do not come within the scope of” the rules applicable to such relationships.[xvi] According to the regulations, “[s]uch transactions are governed by” the rules applicable to First Category relationships[xvii] “for the purposes of which the partnership is considered to be an entity separate from the partners.”[xviii]
Partner-Partnership Loss Transaction
As stated earlier, no deduction is allowed in respect of any loss from the sale of property between a partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest or profits interest in such partnership.[xix]
For purposes of illustration, assume the following simplistic scenario: Spouse 1 is married to Spouse 2; Spouse 1 owns 5 percent and Spouse 2 owns 90 percent of the capital and profits interests of Partnership; Spouse 2’s cousin It owns the other 5 percent; Brother is Spouse 1’s sibling and has no relationship with either Spouse 2 or Spouse 2’s cousin It; among other assets, Partnership owns Property with an adjusted basis that exceeds Property’s current fair market value (i.e., there is a built-in loss); Partnership is considering the sale of Property to Brother.
Pursuant to the family attribution rule, Brother is treated as owning his sibling’s – Spouse 1’s – 5 percent interest in Partnership. Spouse 1 is treated as owning the 90 percent interest in Partnership held by Spouse 2. However, no part of Spouse 2’s interest is re-attributed from Spouse 1 to Brother because, as stated above, back-to-back family attribution is not permitted; nor is any of Spouse 2’s interest (direct or indirect) attributed to Brother.[xx] Therefore, Brother is treated as constructively owning only 5 percent of Partnership. Brother and Partnership are not treated as related persons because the more-than-50 percent ownership threshold is not satisfied.
Consequently, the loss disallowance rule applicable to First Category relationships will not cover the sale of Property at a loss from Partnership to Brother.[xxi]
Because the non-partner-partnership relationship (between Brother and Partnership) does not present a Second Category relationship, and because it does not satisfy the criteria for treatment as a First Category relationship, one may conclude that the loss arising from the sale of Property from Partnership to Brother is not subject to either of the two loss disallowance rules described above.
Unfortunately, that conclusion would be wrong.
Second Category – Aggregate Theory
Notwithstanding that, on the face of the Code, partners and partnerships are not identified as a Second Category transactional relationship, current IRS regulations provide that sales between partnerships and non-partners that are not subject to the loss disallowance rule for First Category relationships[xxii] (as in the case of Brother and Partnership) may nevertheless be subject, in part, to the disallowance rule applicable to Second Category relationships.[xxiii]
Specifically, these current regulations provide that such a “transaction . . . between a partnership and a person other than a partner shall be considered as occurring between the other person and each member of the partnership separately.”[xxiv]
These regulations are premised on the “aggregate theory” of partnership taxation pursuant to which the partnership is not viewed as an entity separate from its partners but, rather, as the aggregation of its individual partners, each of whom is treated as owning an undivided interest in the assets of the partnership.
Therefore, if a non-partner is party to a loss transaction with a partnership, and if such non-partner is described in a Second Category relationship with any partner of the partnership, then no deduction with respect to such transaction shall be allowed:
(i) To any partner who is related to the non-partner to the extent of the partner’s distributive share of the partnership’s deduction for the loss arising from the partnership’s sale of property to such non-partner, and
(ii) To the non-partner to the extent the related partner is deemed to have acquired an interest in any property sold to the partnership at a loss by the non-partner.[xxv]
Stated differently, the loss disallowance rule applicable to Second Category relationships[xxvi] is applied to a transaction between a non-partner and a partnership to the extent of the proportionate interest of any partner in the partnership who is related to the non-partner.
Thus, under current regulations the sale of Property from Partnership to Brother would be considered as occurring separately between Brother and each of the partners of Partnership.
The sale considered as occurring between Spouse 1 and Brother falls within the scope of the loss disallowance rule applicable to Second Category relationships because Spouse 1 and Brother are family members (siblings), and no deduction would be allowed for Spouse 1’s share (5 percent) of the loss arising from the sale of Property to Brother.
However, the sales considered as occurring between Spouse 2 and their cousin It on the one hand[xxvii] and Brother on the other hand are not subject to this rule; therefore, each of Spouse 2 and cousin It may deduct their respective 90 percent and 5 percent distributive shares of Partnership’s loss.
The Proposed Regs
The IRS recently proposed regulations relating to the disallowance of deductions for losses in certain transactions between partnerships and related persons.[xxviii] In the preamble to the proposed regulations the IRS explained that Congress intended for a partnership to be treated as an entity separate from its partners rather than an aggregate of its partners for purposes of applying the related party loss disallowance rules.
Consistent with Congressional intent, the IRS proposed the removal of the aggregate approach utilized by the above-described regulation,[xxix] effective for sales that occur in taxable years ending on or after the date the proposed regulations are published as final regulations in the Federal Register.
According to the proposed regulations, the entity approach – under which the partnership would be treated as a separate taxpayer from its partners – should be applied when a partnership engages in a purchase and sale transaction with a non-partner in which loss is realized by either the partnership or the non-partner. In that case, the loss disallowance rule would be applied to the partnership and not to its partners.
Consequently, that loss would not enter into the computation of the partnership’s taxable income – the proportionate disallowance that is currently applied on a per-partner basis under the current regulations would be replaced by the total disallowance of such loss at the partnership level.
The changes that would be effected by the proposed regulations, if adopted, would eliminate the irrational difference in outcomes under the current rules.
As illustrated above, a loss realized in a sale between a non-partner and a related partnership (a First Category relationship) is disallowed entirely under the existing rules, whereas a loss realized between a non-partner and an unrelated partnership that would be allowed in its entirety under the same First Category relationship rules may still be disallowed on a proportional, per partner, basis under the rules applicable to Second Category relationships.
By applying the entity approach to partnerships consistently across these loss disallowance rules, the proposed regulations ensure consistent outcomes and eliminate what has certainly been a trap for the unwary in the analysis of related party loss transactions.
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[i] IRC Sec. 1. The maximum rate is scheduled to revert to 39.6% in 2026, with the sunset of many other Code provisions enacted by the Tax Cuts and Jobs Act (Pub. L. 115-97).
The 3.8 percent surtax on net investment income may also apply to this income. IRC Sec. 1411.
[ii] IRC Sec. 1239. Thus, if a taxpayer were to sell an improved real property to a purchaser that is “related” to the taxpayer, the portion of the gain attributable to the depreciable improvement (say, a building) may be taxed as ordinary income.
The underlying theory: a taxpayer should not be able to realize capital gain on a sale that provides a related party with a cost basis that may be recovered against ordinary income through depreciation.
[iii] Not necessarily a partner.
[iv] IRC Sec. 707(b)(2). For example, the entire gain from a sale of real property between related partnerships, may be taxed as ordinary income if the property is not a “capital asset” in the hands of the buyer. IRC Sec. 1221. For example, real property that is held for use by the taxpayer in the taxpayer’s trade or business.
[v] IRC Sec. 267(a)(1); Sec. 707(b)(1).
The underlying theory: the property may still appreciate in the hands of the related buyer and, so, the related parties as a whole will not have realized a loss.
It should be noted that if a taxpayer acquires property by purchase from a related transferor who, on the transaction, sustained a loss not allowable as a deduction by reason of IRC Sec. 267(a)(1) or Sec. 707(b)(1), then any gain realized by the taxpayer on a later sale of the property is recognized only to the extent that the gain exceeds the amount of the loss allocable to the property. IRC Sec. 267(d); Reg. Sec. 1.267(d)-1(a)(1); the penultimate sentence of Sec. 707(b)(1).
[vi] IRC Sec. 707(b).
[vii] IRC Sec. 267(b).
[viii] The other covered relationships are as follows:
- A grantor and a fiduciary of any trust;
- A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts;
- A fiduciary of a trust and a beneficiary of such trust;
- A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts;
- A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust;
- A person and an organization to which IRC Sec. 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual; and
- An executor of an estate and a beneficiary of such estate (except in the case of a sale or exchange in satisfaction of a pecuniary bequest).
[ix] It is not necessary that the family member to whom stock is attributed own stock in the corporation. Reg. Sec. 1.267(c)-1(a)(2).
[x] For example, if a partnership owns stock in a corporation, the partnership’s ownership is attributed to its partners on a pro rata basis. The stock thus attributed to a partner that is an individual may be attributed from such individual to a member of their family. However, such family member may not further attribute such ownership to yet another family member.
[xi] IRC Sec. 267(c). Thus, there is no back-to-back family attribution.
[xii] IRC Sec. 267(b).
[xiii] IRC Sec. 267(b)(10).
[xiv] I.e., IRC Sec. 267(a)(1).
[xv] Under Sec. 707(b) of the Code.
[xvi] IRC Sec. 267.
[xvii] IRC Sec. 707.
[xviii] Reg. Sec. 1.267(b)-1(b)(1).
[xix] A First Category relationship, which also includes transactions between two partnerships in which the same persons own, directly or indirectly, more than 50% of the capital interests or profits interests.
[xx] Spouse 2 and Brother are not family members.
[xxi] Alternatively, if Trust was created by Spouse 2 as a nongrantor trust for the benefit of Spouse 1, and if Trust (instead of Spouse 2) held the 95% intertest in Partnership, and if Spouse 1 was the only beneficiary of Trust, then the interest owned by Trust would be attributed to Spouse 1 (under the entity-to-owner attribution rule), and reattributed from Spouse 1 to Brother (under the family attribution rule), then Brother and Partnership would be in a First Category relationship and the loss on the sale of Property to Brother would be disallowed under IRC Sec. 707(b).
[xxii] IRC Sec. 707(b).
[xxiii] IRC Sec. 267(a)(1).
[xxiv] Reg. Sec. 1.267(b)-1(b)(1).
[xxv] Reg. Sec. 1.267(b)-1(b)(1).
[xxvi] IRC Sec. 267(b).
[xxvii] Not a reference to Thing.
[xxviii] REG-131756-11, 88 FR 82792-01 (Nov. 27, 2023). Comments on the proposed regulations are due by February 26, 2024.
[xxix] Reg. Sec. 1.267(b)–1(b).