Related Party rules

Loss Disallowance Rules

A taxpayer may not deduct a loss realized on a sale of property to or an exchange of property with a Related Person. Although the seller in a Related Person transaction may not deduct a loss, in some cases, the purchaser may offset subsequent gain realized on a subsequent the sale of that property. The offset is allowed: 1) if the sale is to a non-Related Person and 2) if the Related Person purchaser resells the property at a gain.

To demonstrate the operation of the offset rule, please consider the following example. Suppose Mr. A sells property in which he has an adjusted basis of $1,000 to his sister, Ms. B, for its fair market value of $750. Mr. A's realized loss of $250 is not allowed under the loss disallowance rules. If Ms. B is able to sell the property later to a non-Related Person for $1,100, her gain of $350 (determined by subtracting from the $1,100 amount realized on the sale her adjusted basis of $750) is offset by Mr. A's disallowed loss. Ms. B reports only $100 gain instead of $350.

Income and Deduction Matching Rules

The matching rule requires that an accrual method taxpayer delay a deduction arising out of a payment to a Related Person until the Related Person-payee includes the amount in income. The rule applies only if the payee uses the cash method of accounting. Consequently, matching is not required when the Related Person ordinarily employs the accrual method of accounting in his business. In some cases, a Related Person-payee is automatically placed on the accrual method of reporting income and in these cases the matching rule does not apply. Typical cases in which a taxpayer must report income on the accrual method of accounting include the reporting of certain interest known as “original issue discount” (OID) and the reporting of income under the completed contracts method.

The matching principle is demonstrated in the following example in which both taxpayers use the calendar year as the taxable year. Tom employs the accrual method of accounting in his business, reporting deductions for costs incurred when services have been provided to him and the bill has been received. Tom owns 55% of the stock of X Corp. X Corp provides accounting services to Tom in November, 2005 and mails its bill to Tom, which he receives on December 1, 2005. X Corp reports income on the cash method of accounting when payment has been received. X Corp receives payment on January 10, 2006. X Corp does not report income from the payment until calendar year 2006. Because Tom and X Corp are Related Persons, Tom may not claim the deduction in 2005 in accordance with his customary practice. Instead he may not claim the deduction until 2006, the year in which X Corp reports the income arising out of the services rendered to Tom, the Related Person.

Definition of Related Persons

The following are considered Related Persons:

(1) Family members (including siblings, spouses, lineal descendants, and ancestors),

(2) A corporation and an individual owning (directly or indirectly) more than 50% in value of the outstanding stock,

(3) Two corporations that are members of the same controlled group,

(4) A grantor and a fiduciary of a trust,

(5) A fiduciary of a trust and a fiduciary of another trust, if the same person is grantor of both trusts,

(6) A fiduciary of a trust and a beneficiary of the trust,

(7) A fiduciary of a trust and a beneficiary of another trust, if the same person is grantor of both trusts,

(8) A fiduciary of a trust and a corporation in which the trust (or the grantor) owns (directly or indirectly) more than 50% in value of the outstanding stock,

(9) An educational or charitable organization exempt from tax and a person which controls (directly or indirectly) the organization alone (or through his family members, if the person is an individual),

(10) A corporation and partnership if the same persons own - (A) more than 50% in value of the outstanding stock of the corporation, and (B) more than 50% in value of the capital interest of the profits interest in the partnership,

(11) An S corporation and another S corporation if the same persons own more than 50% in value of the outstanding stock of each,

(12) An S corporation and a C corporation if the same persons own more than 50% in value of the outstanding stock of each corporation,

(13) 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.

Pass-thru Entities and Controlled Groups of Corporations

There are special rules regarding pass-thru entities (partnerships and S corporations) and members of controlled groups of corporations (corporations connected by more than 50% ownership).

In general, pass-thru entities are subject to the deduction matching rules. Although partners and partnerships are not listed as Related Persons, special partnership rules determine allowance of losses in transactions between partners and partnerships. Regarding losses or deductions arising out of transactions between a partnership and a non-partner who is related to a partner, the partner's distributive share of these items and the losses or deductions of the non-partner are disallowed.

For controlled group members, the consolidated return rules determine allowance of losses between Related Persons that are members of controlled groups. In general, these losses are deferred until property is transferred outside the group. The deduction matching rules do apply to members of a controlled group.

Rules Attributing Ownership of Stock to Other Related Persons

Stock may be attributed from one person to another for purposes of determining relationship. Stock owned by a corporation, partnership, or estate is considered to be owned proportionately by the shareholders, partners, or beneficiaries. In many cases, when ownership is attributed to one person it may be re-attributed to another.

An individual is treated as owning the stock held by his family. Once ownership is attributed, there is no further attribution to other family members. An individual who owns stock in a corporation is treated as owning the stock held in that corporation by her partner.

Avoiding Sanctions in Related Person Transactions

Given the clear definition of Related Persons, application of the related party limitations to a transaction is easy to predict. It is difficult to avoid the limitations unless either the transaction is structured with a non-related third party or the relationship is terminated before entering into the transaction (if possible). Circumvention of the Related Person sanctions by use of a friendly non-related intermediary is not likely to be successful because the Service can be expected to employ substance-over-form arguments that will succeed in re-characterization of the transaction as one between Related Persons.