Losses, Expenses and Interest between Related Taxpayers – Know The (Tax) Code: 26 U.S.C. §267

Congress, aware that related parties could create fictitious tax losses lacking economic substance based upon the related parties continued enjoyment of the property subject to the loss, enacted § 267 of the Internal Revenue Code to disallow certain losses and deductions on transactions between related taxpayers.

§ 267(a) disallows two specific types of deductions: (1) a loss on the sale or exchange of property between related parties and (2) a deduction for a payment to a related party who has not included such item in income. A “related party” is defined in § 267 as including family members, a taxpayer and a corporation controlled directly or indirectly (through attribution from other family member stock holdings) by the taxpayer (more than 50% of the value of the stock), and a partner and a controlled (directly or indirectly) partnership. § 267 also specifies other related parties, including a trust and its grantor, a trust and its beneficiary, and a personal services company and any shareholder-employee.

The Tax Code further defines family members as related parties including brothers and sisters, spouse, ancestors, and lineal descendants. Half-brothers and half-sisters are related parties. In-laws and step relationships are not unless the relationship is a front or nominee for a related party.

To determine if a corporation and a shareholder are related parties, the constructive ownership rules specified in § 267(c) are applied. These rules effectively equate control with ownership, in that stock held by certain related parties is treated as though it is held by the taxpayer. The same is true of two corporations controlled, directly or indirectly, by the same person.
Any transaction between a personal services corporation and an employee owner are automatically classified as related parties regardless of the ownership percentage of the employee owner.

The attribution rules can be summarized as follows:
Rule 1 – An interest owned directly or indirectly by a corporation, partnership, estate or trust is treated as owned proportionately by its shareholders, partners, or beneficiaries.

Rule 2 – An individual is treated as owning any corporate interests held by his “family,” where family includes brothers, sisters, half-brothers, half-sisters, spouses, ancestors (e.g., parents, grandparents, etc.), and lineal descendants (e.g., children, grandchildren, etc.). Thus, if John owns a 60% interest in X Corporation, his son owns a 15% interest, his grandson owns a 5% interest, and his nephew owns a 10% interest, John is treated as owning 80% of X Corporation (60% + 15% + 5%) For purposes of the attribution rules (his nephew is not a “related party”).

Rule 3– A person having a constructive ownership interest under Rule 1 above, dealing with proportionate attribution, is treated as actually owning that interest for the purposes of applying either Rule 1 or Rule 2 in other situations, as this is not considered double attribution. However, Rule 2 cannot be applied in this manner as this is considered to be double attribution. In the earlier example for Rule 2, John was treated as constructively owning his son’s 10% interest. However, that 10% interest could not also be attributed to John’s brother Joe, since this would involve double attribution with family members going from John’s son to John and then to John’s brother Joe.

If you have any questions about or are contemplating a transaction between you and a family member or “related party,” call THE TAX EXPERTS at the Thorgood Law Firm www.thorgoodlaw.com. For a FREE consultation call 212-490-0704.
Losses, Expenses and Interest between Related Taxpayers - Know The (Tax) Code: 26 U.S.C. §267

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