Related Party Transactions: Internal Revenue Code §267 – Tax Planning

It is common for individuals to make transactions with family members or businesses owned by family members. Did you know that such transactions could potentially have adverse tax consequence for you? The normal tax rules regarding the deductibility of losses are suspended in the case of certain sales between related parties. One specific provision within the Internal Revenue Code, Section 267, was created to prevent taxpayers from shifting ownership of stock or property to a related person or entity in an effort to take advantage of beneficial tax provisions while essentially still controlling their original interest through their related party. In order for any taxpayer to be able to identify if they will potentially be impacted by these related party provisions, they must first understand both the Internal Revenue Code’s definition of related parties and the “constructive ownership” rules of Section 267. Review these key terms and conditions while reviewing your tax planning goals this year.

Definition of Related Parties

Internal Revenue Code §267(b) has a complex set of rules to define who is a related party for tax purposes. The common related parties are defined as the following:

• • Brothers and sisters
  • Spouses
  • Ancestors and lineal descendants (father, son, grandfather)
  • Entities that are more than 50 percent owned, directly or indirectly, by individuals, corporations, trusts, and/or partnerships.
  • Controlled groups (any two entities that are both owned more than 50 percent by the same party)

  Note: In-laws and step relationships are not considered related parties.

  Constructive Ownership

  Under constructive ownership rules of §267, taxpayers are deemed to own stock owned by certain relatives and related entities. There are two key attribution rules regarding constructive ownership:

  • Rule 1: Stock owned directly or indirectly by a corporation, partnership, estate, or trust is treated as owned proportionately by its shareholders, partners, or beneficiaries.
    • Example: Taxpayer John owns 80 percent of XYZ Company, which in turn owns 30 percent of ABC Company.
    • Ownership Result: Taxpayer John is treated as owning 24 percent of ABC (80% X 30%) through his holdings of XYZ stock.
    • Example: Taxpayer Bob owns a 30 percent interest in ABC Corp.; his wife owns a 20 percent interest; his grandson owns a 5 percent interest; and his nephew owns a 15 percent interest.
    • Ownership Result: Taxpayer Bob is treated as owning 55 percent of ABC Corp. (30% + 20% + 5%). His nephew is not included as a related party under §267.

    Capital Gains and Related Parties

    While losses are disallowed on most related party transactions, the general rule is that capital gain taxes are imposed on all sales of non-depreciable property (land) between related parties, with the two exceptions below:

    1. Two spouses – basis is merely transferred because spouses can gift unlimited amounts to each other without income or gift tax consequences.
    2. An individual and a 50 percent or more controlled corporation or partnership (where the gain is taxed as ordinary income).

    Related party transactions under the provisions of the Internal Revenue Code can be quite technical and complex. If you think you might fall within the related party rules or would like to know more about them, please reach out to Travis Koester, Associate, or contact our Tax Solutions team at Mahoney to be of help to you in any way.