One of the most frustrating results upon completing a transaction is failing to realize the anticipated after-tax consequences from the transaction because you were unaware of an applicable tax provision under the Internal Revenue Code.

This issue often arises in “related party” transactions – transactions between parties that are treated as “related” for tax purposes under the Internal Revenue Code. This article focuses on two common “related party” transactions and the tax consequences that can arise from them.

1. When you sell for a loss
2. When you sell for a gain

Internal Revenue Code Section 267(a)(1)

When you sell property at a loss, often the expectation is that you can deduct the loss in the taxable year of sale. However, under Internal Revenue Code Section 267(a)(1), such loss generally is not deductible in the taxable year of sale in a “related party” transaction. Specifically, Internal Revenue Code Section 267(a)(1) provides:

“No deduction shall be allowed in respect of any loss from the sale or exchange of property, directly or indirectly, between persons specified in any of the paragraphs of subsection (b). The preceding sentence shall not apply to any loss of the distributing corporation (or the distributee) in the case of a distribution in complete liquidation.”

The “persons specified in any of the paragraphs of subsection (b)” (described as “Relationships”) are listed in Internal Revenue Code Section 267(b). These “related parties” under Internal Revenue Code Section 267(b) for purposes of disallowing a deduction under Internal Revenue Code Section 267(a)(1) are the following:

• “Members of a family” (which includes, under Internal Revenue Code Section 267(c)(4), an individual and the individual’s spouse, ancestors, lineal descendants, and brothers and sisters (“whether by the whole or half blood”);
• 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” (as defined under Internal Revenue Code Section 267(f));
• 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 Internal Revenue Code Section 501 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;
• A corporation and a partnership (which generally includes a limited liability company if treated for tax purposes as 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;
• 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; and
• Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate.

In determining if there are any of these “related parties” under Internal Revenue Code Section 267(b) for purposes of applying Internal Revenue Code Section 267(a)(1), Internal Revenue Code Section 267(c) sets forth certain “constructive ownership of stock” rules. As two examples, Internal Revenue Code Section 267(c)(1) provides that stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries, and Internal Revenue Code Section 267(c)(2) provides that an individual shall be considered as owning the stock owned, directly or indirectly, by or for his family. One should not analyze any transaction under Internal Revenue Code Section 267(a)(1) without reviewing all of the various “constructive ownership of stock” rules under Internal Revenue Code Section 267(c).

While the impact of Internal Revenue Code Section 267(a)(1) is to disallow deduction of a loss in the taxable year of sale, such disallowed loss can provide some tax benefit in the future. Under Internal Revenue Code Section 267(d), the amount of disallowed loss because of Internal Revenue Code Section 267(a)(1) on the sale of property to a “transferee” generally can be applied to reduce the amount of recognized gain when such “transferee” sells such property.

Internal Revenue Code Section 1239(a)

Another example of a “related party” transaction can arise if you sell property at a gain. When you sell property at a gain, often the expectation is that you can realize the income from the gain as “more favorably-taxed” capital gain, rather than as “less favorably-taxed” ordinary income. However, under Internal Revenue Code Section 1239(a), such gain generally is taxable as ordinary income, and not as capital gain, in a “related party” transaction.

Specifically, Internal Revenue Code Section 1239(a) provides:

“In the case of a sale or exchange of property, directly or indirectly, between related persons, any gain recognized to the transferor shall be treated as ordinary income if such property is, in the hands of a transferee, of a character which is subject to the allowance for depreciation provided in section 167.”

The “related persons” for purposes of “ordinary income” treatment under Internal Revenue Code Section 1239(a) are listed in Internal Revenue Code Section 1239(b). These “related persons” are the following:

• A person and all entities which are “controlled entities” with respect to such person. Under Internal Revenue Code Section 1239(c)(1), a “controlled entity” is, with respect to any person, a corporation more than 50 percent of the value of the outstanding stock of which is owned (directly or indirectly) by or for such person, a partnership (again, which generally includes a limited liability company if treated for tax purposes as a partnership) more than 50 percent of the capital interest or profits interest in which is owned (directly or indirectly) by or for such person, and any entity which is a “related person” to such person under Internal Revenue Code Sections 267(b)(3) (two corporations which are members of “the same controlled group” (as defined under Internal Revenue Code Section 267(f)), 267(b)(10) (a corporation and a partnership (again, which generally includes a limited liability company if treated for tax purposes as 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), 267(b)(11) (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), or 267(b)(12) (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). In reviewing if there is a “controlled entity” under Internal Revenue Code Section 1239(c)(1) for purposes of Internal Revenue Code Section 1239(b), ownership shall be determined in accordance with rules similar to the “constructive ownership of stock” rules under Internal Revenue Code Section 267(c) (other than Internal Revenue Code Section 267(c)(3));
• A taxpayer and any trust in which such taxpayer (or his spouse) is a beneficiary, unless such beneficiary’s interest in the trust is a “remote contingent interest” (within the meaning of Internal Revenue Code Section 318(a)(3)(B)(i)); and
• Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate.

In addition, under Internal Revenue Code Section 1239(d), both (1) an employer and any person “related” to the employer (within the meaning of the above rules of Internal Revenue Code Section 1239(b)), and (2) a “welfare benefit fund” (within the meaning of Internal Revenue Code Section 419(e)) which is controlled directly or indirectly by persons referred to in clause (1), shall be treated as a “related person” for purposes of Internal Revenue Code Section 1239(a).

While there is some overlapping scope, it should be noted that the specific scope of “related parties” for purposes of a “related party” transaction under Internal Revenue Code Section 1239(a) is different than the specific scope of “related parties” for purposes of a “related party” transaction under Internal Revenue Code Section 267(a)(1).

As an additional point, while Internal Revenue Code Section 1239(a) only applies to the sale or exchange of depreciable property, under Internal Revenue Code Section 1239(e), “a patent application” is treated as depreciable property for purposes of Internal Revenue Code Section 1239.

This article has focused on “related party” transactions under Internal Revenue Code Section 267(a)(1) and Internal Revenue Code Section 1239(a). There are many other “related party” transactions under the Internal Revenue Code where the “related” nature of the parties to the transaction can lead to unanticipated after-tax consequences, including without limitation, under Internal Revenue Code Section 36(c)(3) (relating to the “first-time homebuyer credit”), Internal Revenue Code Section 179(d)(2) (relating to the election to expense depreciable business assets), Internal Revenue Code Section 267(a) (2) (relating to the matching of deduction and income in the case of expenses and interest), Internal Revenue Code Section 453(e) (relating to “second dispositions” after installment sales), Internal Revenue Code Section 707(b) (relating to sales with respect to “controlled partnerships”), Internal Revenue Code Section 1031(f) (relating to certain transactions after “like-kind exchanges”), and Internal Revenue Code Section 1235(c) (relating to sales of patents).

If you are engaging in any transaction with a family member, with an affiliated or controlled entity, or with any other person or entity that could be viewed as a “related party”, you need to review if the transaction is a “related party” transaction under the Internal Revenue Code and, if so, fully understand the after-tax consequences of the transaction. You do not want to be surprised by a “related party” transaction and face unexpected tax liability.

If you have any questions concerning any “related party” transaction, please discuss this issue with your advisers.

Note – Joint Liabilities

Joint liabilities can arise when multiple persons serve in the same liability position under a contract or agreement. A common example of a joint liability is evidenced when multiple “roommates” rent an apartment. They are part of the collective term, “tenant”, under a written lease, which will govern their joint agreement with their landlord. However, this written lease by itself (other than generally stating that each “roommate” is jointly and severally liable for all “tenant” obligations) generally will not address the relative rights and obligations of the “roommates” with respect to each other. What happens if one “roommate” does not pay his appropriate share of “tenant” obligations, and thereby other “roommates” as “tenant” in effect pay more than their appropriate share of “tenant” obligations? What happens if the tortious conduct of one “roommate” creates damages to or on the leased property, and thereby other “roommates” as “tenant” in effect are liable to the landlord or another person for such damages? Whether in the case of “roommates” who are collectively the “tenant” under a written lease, or in other “joint liability” situations, a separate written agreement among the persons subject to the applicable joint liability can help to resolve their relative rights and obligations with respect to each other and address the issues described above. This separate written agreement among the persons subject to the applicable joint liability can be beneficial to better protect the respective positions of all of the persons subject to the applicable joint liability.

If you have any questions concerning how to best address any “joint liability” situation, please discuss this issue with your advisers.