If you are considering, or planning, to buy or sell business assets or an ownership interest (corporate stock or a partnership or LLC interest), beware of the tricky “related party” tax rules. The Internal Revenue Code contains a number of rules aimed at penalizing sales between individuals or entities that are considered closely connected and thus more likely to try to beat the federal government out of tax revenue.
The issue is that the rules are not very well known, are quite complicated, and reflect a notion of “related” that far exceeds what most people would have reason to suspect. These provisions can snare perfectly legitimate purchase-sale transactions that weren’t concocted just to avoid taxes.
Here are four especially unfavorable “related party” rules:
1. Disallowed Loss From a Sale
This rule disallows the seller’s tax loss when a “related party” buys an asset, including a business ownership interest.
The disallowed loss doesn’t disappear, but instead is added to the buyer’s tax basis. This reduces the buyer’s taxable gain, or increases the taxable loss, when the buyer eventually sells the asset or ownership interest later on. However, the extra basis never does the seller any good.
A similar rule can potentially disallow a loss from the sale of an asset between a partnership and a majority partner or between two partnerships that are considered to have common ownership, and even further, there is another rule that can disallow a portion of a loss between a partnership and a taxpayer considered to be “related” to a partner of that firm.
The latter two rules can also apply to multi-member LLCs treated as a partnership for tax purposes. [Sources: Section 267(a)(1) and Section 707(b)(1) of the Internal Revenue Code and Treasury Regulation 1.267(b)-1(b).]
2. Disallowance of Capital Gain Treatment for Profit from a Sale
This rule can come into play when an appreciated asset is sold to a “related party” who will be able to depreciate the asset under applicable tax rules. This rule can also potentially convert low-taxed capital gains into high-taxed ordinary income.
A somewhat similar rule can apply to the sale of an appreciated asset between a partnership and a majority partner when the asset will not be a capital asset in the hands of the buyer. Generally, this means an asset the buyer can depreciate under applicable tax rules or land the buyer will use for business purposes. (Sources: Section 1239(a) and Section 707(b)(2) of the Internal Revenue Code.)
3. Disallowance of Gain Deferral for Installment Sale Profit
When there is a gain from a sale between “related” parties, this rule can disallow favorable installment sale treatment, which generally postpones the recognition of taxable gain until the seller actually receives cash from the buyer.
When the disallowance rule applies, the seller must include the entire gain in taxable income for the year of sale, whether or not any cash changed hands. This provision applies only to assets that the buyer can depreciate. (Source: Section 453(g) of the Internal Revenue Code.)
4. Disallowance of Amortization Deduction for a Purchased Intangible Asset
A so-called anti-churning provision can prevent the buyer from claiming amortization deductions for an intangible asset purchased from a “related party.” (Source: Section 197(f)(9) of the Internal Revenue Code.) Unfortunately, the Internal Revenue Code includes several other unfavorable provisions that can potentially create adverse tax results for sales between “related parties.”
To make matters more difficult, the definitions of what constitutes “related parties” are complicated, and are not necessarily the same for each rule. For example, Rule Number 1 above can apply to a sale between a corporation and a partnership when the same taxpayers own more than 50 percent of both entities. This may seem fairly straight forward, but it isn’t because ownership of corporate stock can be attributed to “related” taxpayers who don’t directly own any shares themselves.
It gets worse. Similar attribution rules can create “phantom” ownership by taxpayers who do not have any direct ownership of non-corporate entities such as partnerships and multi-member LLCs treated as partnerships for federal tax purposes.
Bottom Line: “Related party” rules can sneak into unexpected situations, so seek professional advice from Filler & Associates before making a significant purchase-sale transaction if you have even the slightest suspicion that the other party is “related” to you under the tax law. In many cases, proper advance planning can mitigate or avoid unfavorable tax results.