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Related Party Issues in National Income Tax

This chapter explores the various issues and relationships related to related parties in national income tax, such as family members, corporations, trusts, and constructive ownership. It covers rules for stock ownership, gain on depreciable property, and more.

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Related Party Issues in National Income Tax

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  1. Related Party IssuesChapter 2 pp. 33-62 2016 National Income Tax Workbook™

  2. Issue 1 p. 34§ 267(b) Relationships • Family: brothers/sisters (whole or half), spouse, ancestors, lineal descendants • Corp & individual owning > 50% directly or indirectly of the corp (by stock value) • 2 corp members of controlled group using 50% in place of 80% [§ 1563(a)] • Grantor and fiduciary of any trust

  3. Issue 1 p. 34§ 267(b) Relationships • Fiduciaries of trusts with same grantor • Fiduciary and beneficiary of a trust • Fiduciary of a trust and beneficiary of another trust with same grantor • Fiduciary of trust and a corp in which trust grantor owns > 50% stock (value) • § 501 org and those controlling it

  4. Issue 1 pp. 34-35§ 267(b) Relationships • Corp & partnership (PS) if same persons own > 50% of each • 2 S corps if each owned > 50% (value) by same persons • S corp & C corp if each owned > 50% (value) by same persons • Executor and beneficiary of an estate

  5. Issue 1 p. 35§ 267(b) Relationships Note: • Partner (PN) & PS not covered by § 267 • Personal service corp (PSC) and employees related for matching deductions and gross income inclusion • Family attribution rules override hostility among family members!

  6. Issue 1 p. 35§ 267(c) Constructive Ownership • Stock owned directly or indirectly: • By corp, PS, estate, trust deemed owned proportionately by owners/beneficiaries • By family deemed owned by the individual • By an individual PN deemed owned by another individual PN if also owns corp stock • Family (limited as defined earlier) • #1 carries over to application of #1, #2 & #3 but application of #2 or #3 stands alone

  7. Issue 1 pp. 35-36§ 318 Constructive Ownership • Stock owned directly or indirectly: • By spouse, children, parents, grandchildren, deemed owned by individual (not siblings) Example 2.1 – p. 36 • By PS, S corp, or estate deemed owned proportionately by owners/beneficiaries • By trust deemed owned by beneficiaries in proportion to actuarial interest in trust

  8. Issue 1 p. 36§ 318 Constructive Ownership • Stock owned directly or indirectly: • By a trust is deemed owned by the trust owner (grantor or other substantial owner) • By C corp deemed owned proportionately by shareholder (SH) owning directly/indirectly ≥ 50% of the C corp • By PN, S corp SH, or estate beneficiary deemed owned by PS, S corp, or estate

  9. Issue 1 p. 36§ 318 Constructive Ownership • Example 2.3 • Amanda owns 50% PS, 50% C corp • PS owns 50% C corp • Deemed ownership: • Amanda – 75% (50% + 50% x PS 50%) • PS – 100% (50% + Amanda’s 50%)

  10. Issue 1 pp. 36-37§ 318 Constructive Ownership • Stock owned directly or indirectly: • By a beneficiary of a trust deemed owned by the trust unless < 5% trust value actuarially Example 2.2 – p. 36 • By a person considered trust owner deemed owned by trust • By a person owning ≥ 50% of corp (value) deemed owned by corp

  11. Issue 1 p. 37§ 318 Constructive Ownership • Stock options treated as stock owned • Stock attributed only once under family rule • Stock deemed owned by PS, estate, trust, or corp under 6, 7, 8, and 9 (from owners, etc) not treated as owned by Corp for 2, 3, and 4 (to owners, etc) • Similar attribution rules impact ACA

  12. Issue 1 p. 37§ 707(b)(1) and (b)(2) If sale/exchange is between the following: • PS & person owning > 50%, directly or indirectly, capital or profits interest or • 2 PSs owned > 50% directly or indirectly (capital, profits interests) by same persons • No loss allowed • Gains ordinary (unless capital asset)

  13. Issue 1 pp. 37-38§ 1239 Gain on Depreciable Property • Ordinary gain if related buyer will depreciate • Person & all entities controlled (50%) • § 267(b) - #3, 10, 11, 12 (pp. 34-35) • TP & trust if TP (spouse) beneficiary • Estate executor and beneficiary • Employer & controlled welfare benefit

  14. Issue 1 p. 38§ 1239 Gain on Depreciable Property Example 2.4 • SG Realty, LLC, owned 50/50 Sam and son, George (partnership) • George sells a commercial rental to SG • Gain of $ 300,000 is ordinary • George constructively owns 100% SG

  15. Issue 1 p. 38§ 1563(d) Rules for Stock Ownership • Parent-subsidiary controlled group • Stock directly owned by corp • Stock constructively owned through options, PSs, estates, and trusts • Brother-sister controlled group • Stock directly owned by individual, trust. or estate • Stock constructively owned via § 1563(e)

  16. Issue 1 p. 38§ 1563(e) Constructive Ownership • Stock options treated as stock owned • Partnership to Partner: ≥ 5% partner (capital or profits) owns % share of stock of partnership • Estate/trust to beneficiary: beneficiary with ≥ 5% actuarial interest owns % share stock • Grantor (owner) owns stock trust holds

  17. Issue 1 pp. 38-39§ 1563(e) Constructive Ownership • Corporation to shareholder: Stock held by corporation attributed to ≥ 5% shareholder proportionately • Spousal – generally stock owned by one spouse owned by the other • Exception if 4 tests met

  18. Issue 1 p. 39§ 1563(e) Constructive Ownership • Child < age 21 owns parent’s stock • Parent owns stock of child < age 21 • Individual owning > 50% stock voting power or value deemed to own stock of: • Parents • Grandparents • Grandchildren • Adult children (21 and older)

  19. Issue 2 pp. 39-40Matching Expense Deductions • Payment to related deductible in year related includes in income • Example 2.5 • Xavier owns 100% accrual XD Corp • Xavier holds note of XD • 2016: No interest paid, $8,300 accrued • $8,300 not deductible until paid • If no longer related, still defer until paid

  20. Issue 3 p. 40Sale of Property at a Loss • No deduction for losses on direct or indirect sale between related parties • Bona fide sale at FMV has no effect • Example 2.6 • Darla sells land to daughter, Carol • Sale price $95,000, Basis $100,000 • $5,000 loss not deductible • Carol’s basis $95,000

  21. Issue 3 p. 40Subsequent Property Sale • If related purchaser sells to unrelated, gain recognized to extent it exceeds loss disallowed • Example 2.7 • Carol sells to unrelated for $101,000 • Realized gain - $6,000 (101,000 – 95,000) • Recognized gain - $1,000 (6,000 - 5,000) • If sold for $93,000: $2,000 loss ($93K-$95K)

  22. Issue 3 pp. 40-41Basis of Disallowed-Loss Property • Purchaser’s depreciable basis = cost • On sale, only gain due to appreciation is reduced by disallowed loss • Example 2.8 (p. 41) • Roger buys equipment from father $ 45,000 • Father has disallowed loss of $ 5,000 • Depreciates on $45,000, sells for $46,000 • See Figure 2.2 for result

  23. Issue 3 p. 41Gift of Depreciable Asset • Example 2.9 • If father gifted property to son: • Roger’s basis for depreciation and computing gain on sale: $50,000 • Roger’s basis for computing loss on sale: $45,000 • (lesser of carryover basis or FMV)

  24. Issue 4 p. 42Like-Kind Exchanges – General Rules • No gain or loss if exchange of property • Held for productive use in trade or business or held for investment • N/A: inventory, securities, PS interests, certificates of trust, beneficial interests, certain intangibles • Real estate = generally like kind • Personal property: narrow definition

  25. Issue 4 p. 42Like-Kind Exchanges – General Rules • Gain recognized = FMV unlike property, cash, or cash equivalent received • Loss recognized if transfers unlike property with FMV < adjusted basis • Basis of property received = • Basis of property given up • Less: Boot received & loss recognized • Plus: Gain recognized

  26. Issue 4 p. 42Like-Kind Exchanges – General Rules • Deferred exchange qualifies • Replacement property must be: • Identified w/in 45 days of giving up prop and • Received by earlier of 180 days after giving up property or due date of return • Requires qualified intermediary

  27. Issue 4 pp. 42-43Like-Kind Exchanges – Related Parties • Disposition by either party within 2 years forces recognition of gain or loss • Recognition as of date of early disposition • Excluded: • Dispositions due to death of either • Involuntary conversions • If convinces IRS no tax avoidance motive

  28. Issue 4 p. 43Like-Kind Exchanges – Related Parties • Example 2.10 - 2015: Mother and Son • Emily: A FMV $100,000, adj. basis $ 60,000 • Arthur: B FMV $100,000, adj. basis $ 80,000 • Arthur sells to unrelated in 2016 - $102,000 • Arthur: Recognize gain of $22,000 (2016) • Emily: Recognize gain of $40,000 (2016) Increase basis in B to $100,000 • Example 2.11 Disposition due to death

  29. Issue 4 p. 43Like-Kind Exchanges – Related Parties • Report exchange and early disposition on Form 8824 • Tax avoidance generally N/A • Early disposition is nonrecognition transfer • No tax advantage from shifting basis on the transferred properties • Exchange involved increasing the party’s interest in a property

  30. Issue 4 pp. 43-44Like-Kind Exchanges – Related Parties • Example 2.12 • Father and son exchange, farm land • Tommy: A FMV $200,000, adj. basis $120,000 • Ken: B FMV $ 200,000, adj. basis $80,000 • Ken immediately sold to hospital • Recognition avoided if • Exchange with hospital for like-kind • Qualified intermediary buys replacement

  31. Issue 5 p. 44I.R.C. § 179 Expense • Expense up to $500,000 for 2016 • Max reduced for total of qualifying property placed in service > $2,010,000 • Purchase from related not qualified • Section 267(b) relationships • Section 707(b) relationships • Within controlled group (using > 50%) (No sibling attribution)

  32. Issue 5 p. 44I.R.C. § 179 Expense • Example 2.13 • Father and son own PJ Corp 50/50 • PJ sold equipment to father, Paul • Paul deemed to own 100% of PJ • Equipment does not qualify for § 179 • If brothers, no attribution – § 179 o.k.

  33. Issue 6 p. 45Installment Sales – General Rules • At least one payment after year of sale • Recognize income as payments received • Depreciation recapture reported in year of sale • Must elect out of installment method • By due date of return • N/A: dealer dispositions, personal property, nonfarm inventories

  34. Issue 6 p. 45Installment Sales – Related Parties • Use only for nondepreciable prop. sales • Unless can prove tax avoidance not key • Gain accelerated if a second disposition within 2 years of first sale • Gain reported in year of second sale • Amount realized = second sale price • No acceleration if can prove neither sale for primary purpose of tax avoidance

  35. Issue 6 pp. 45-47Installment Sales – Related Parties • Example 2.14 • 4/2015 Sally sold land to daughter Jackie • $240,000: $60,000 down + 3 @ $60,000 • Sally’s basis = $144,000 • Figure 2.3: Gross profit % = 40% • 2016 Jackie sells for $ 250,000 • Figure 2.4: $72,000 2016 gain for Sally • Figure 2.5: Sally’s Form 6252 for 2016

  36. Issue 6 pp. 47-48Installment Sales – Related Parties Example 2.15 • In 2016, Jackie sells land for $210,000 • $30,000 less than Sally’s sale price • 2016: Figure 2.6 – Sally’s gain $60,000 • 2017: $60,000 gain not taxable • 2018: Figure 2.7 - $12,000 gain taxable

  37. Issue 6 p. 48Installment Sales – Related Parties • Depreciable property • Installment o.k. if no tax avoidance • No significant tax deferral • Related parties • § 1239(b) definition • 2 or more PS under § 707(b) • Family members not related

  38. Issue 7 pp. 48-50Sale/Exchange Depreciable Property • § 1239: Gain to related seller ordinary if buyer will depreciate • Example 2.16 : Figure 2.8 • Gain on § 351 exchange of depreciable property is ordinary – Rev. Rul. 60-302 • Liabilities > basis • Money or other property received • Example 2.17: Figure 2.9

  39. Issue 8 pp. 50-51Partnership Interest Buyout • Two-step partner buyout to address related party provisions • Facts: • Equal PNs – father, son, nephew • Son to leave partnership • Buy-sell agreement requires 2 steps • Distribute 1/3 of each asset to son • PS purchases back each 1/3

  40. Issue 8 pp. 50-51Partnership Interest Buyout • Step 1 – Distribution of 1/3 each asset in liquidation of son’s PS interest • Proportionate distribution • No gain or loss to partnership • Gain for son if cash, liability relief, marketable securities > his PS basis • Son & partnership no longer related

  41. Issue 8 pp. 50-51Partnership Interest Buyout • Step 2 – Installment purchase of assets • § 1239 will not make gain ordinary • Depreciation recapture reportable • Son not prohibited from claiming loss under § 707 but note: 50% of loss on sale disallowed due to father as partner – Reg. 1.267(b)-1(b)

  42. Issue 9 pp. 51-52At-Risk Limitations & Related Parties • At-risk amount limits loss deduction • Generally at-risk in an activity for • Money & adj. basis of property contributed • Amounts borrowed for use in the activity for which personally liable or property pledged for activity loan

  43. Issue 9 pp. 51-52At-Risk Limitations & Related Parties • No at-risk if borrowed from other owner in activity or one related to other owner • Related uses §§267(b) & 707(b)(1) • Apply > 10% in place of > 50% • Includes persons with interest in businesses under common control • Exceptions – p. 52

  44. Issue 10 p. 52Sale of a Passive Activity • Passive activity general rules • Losses limited to passive income • Passive activity: Trade or business without material participation & rental • Real estate prof. special rules • Active participation rental losses deductible up to $25,000/year • Suspended losses carry forward

  45. Issue 10 p. 53Sale of a Passive Activity • Example 2.18: Figure 2.81 - PAL limited • Sale to unrelated person • 100% in fully taxable transaction, current & suspended losses deductible • Sale to related person – deduct losses if: • TP has other passive income to offset • If related sells in qualifying transaction • Related: §§267(b) & 707(b)(1)

  46. Issue 10 p. 53Sale of a Passive Activity • Example 2.19 Sale to unrelated person • Figure 2.11 – Z activity sold • Deduct current & suspended losses • Example 2.20 Sale to related person • Deduct only losses up to gain on sale and current year passive income • Carryover excess as PAL – triggered if related later sells in qualifying sale

  47. Issue 10 p. 54Sale of a Passive Activity • Nonrecognition transaction • Losses deductible against gain triggered by receipt of boot • Gift of a passive activity • Suspended losses added back to basis to become basis to recipient • Allocate in proportion to % gifted • Example 2.21

  48. Issue 11 pp. 54-55Rental of Home • § 280A & dwelling used as a residence • Limits some deductions • Exclude income if rented < 15 days • Defines dwelling unit as residence used for personal for more than > of • 14 days or • 10% of total days rented at fair rental value (FRV)

  49. Issue 11 p. 55Rental of Home • Personal use days = day used by • Any owner of the unit • An owner’s family member: § 267(c)(4) • Except if main home paying FRV • Individual in a house-swap deal • One not paying FRV (unless § 119) • If repair day, not personal use day • Personal use day not in # of rental days

  50. Issue 11 pp. 55-56Rental of Home • Example 2.22 • Alice rents to brother, Norm • Is Norm’s main home, pays FRV • Alice may deduct all expenses • Figure 2.12 (p. 56)

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