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Issue  244  Article  396
Published:  4/1/2018

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Related Party Pitfalls
Chris Burti, Vice President and Senior Legal Counsel

Part of the 1031 XChange Index - Originally Published 1/1/2010 at STEC

The U.S. Tax Court issued an opinion in 2009 denying 1031 exchange treatment for a forward exchange where the relinquished property was sold to a third party and the replacement property was acquired from a related party. In Ocmulgee Fields, Inc., 132 T.C. No. 6 (2009) the taxpayer sold appreciated property to an unrelated party, through the use of a Qualified Intermediary. Although the taxpayer intended to acquire a replacement property from an unrelated party, it was unable to identify acceptable third party replacement property. As a result, the taxpayer chose to acquire a property from a related entity upon the advice of its tax advisors. The Tax Court upheld the determination of a deficiency by the IRS finding that such an exchange violates the restrictions on exchanges between related parties.

The taxpayer argued that tax avoidance was not a principal purpose of the exchange because there was a business reason for the exchange. The taxpayer further argued that the exchange recombined the replacement property with adjacent property owned by the taxpayer which would increase operating efficiency and would increase the overall value of the combined properties. The Court did not find these allegations credible and held that even if true, the IRS was none the less permitted to find that a principal purpose of the exchange was tax avoidance. .

Section 1031(f) provides special rules for property exchanged between related parties. Under the rules of the Section, there is no nonrecognition of gain or loss to the taxpayer with respect to the exchange of property, if a taxpayer exchanges the property with a related person and the related person disposes of the property within two years of the date of the last transfer in the exchange or if the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer. There is a generic exception to the application of this rule where it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax. However, the Section expressly does not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection. See Internal Revenue Code Section 1031(f)(4).

In the several recent revenue rulings involving the IRS approving exchanges between related parties anticipating disposal by the related party within two years, the IRS has found the absence of basis shifting to be highly persuasive that no impermissible tax avoidance motive existed. In Ocmulgee the taxpayer acknowledged that some basis shifting had occurred but argued: "that the tax impact of a basis differential may be overridden and reversed by more important tax considerations such as rate differentials, lost elections, and the like–not to mention non-tax considerations." The taxpayer listed five "monumental" tax factors that, it argued, overrode the basis differential that it conceded existed here:

(i) the immediate tax on Treaty Fields's sale of the Barnes & Noble Corner,
(ii)  the immediate tax to * * * [petitioner] on the outstanding installment note from Treaty Fields from the earlier sale of the Barnes & Noble Corner to Treaty Fields,
(iii) the decrease in depreciation on the Barnes & Noble Corner,
(iv)  the 34% tax on * * * [petitioner] rather than the 15% tax rate Treaty Fields' partners would have had on the future sale of the Barnes & Noble Corner, and
(v)  The sacrifice of the Section 754 election for Charles Jones [upon his death] which would entirely eliminate 70 percent of the gain from the future sale of the Barnes & Noble Corner to a third party if Treaty Fields had retained ownership.

The Tax Court acknowledged that "there may be situations in which a taxpayer can overcome the negative inference to be drawn from basis shifting and a ‘cash out'…" but concluded that "this is not one of them." The court opined that they were "not prepared to say that, as a matter of law, a finding of basis shifting precludes the absence of a principal purpose of tax avoidance, but, in this case, the immediate tax consequences resulting from petitioner's deemed exchange with Treaty Fields included an approximately $1.8 million reduction in taxable gain and the substitution of a 15-percent tax rate for a 34-percent tax rate. The tax savings are plain, and petitioner's counterfactors are unconvincing or speculative." Thus, in this case the Taxpayer failed to show that the transaction lacked as a principal purpose the avoidance of Federal income tax. Therefore, the actual exchange was deemed to be part of a transaction structured to avoid the purposes of section 1031(f) and, under section 1031(f)(4), the nonrecognition provisions of section 1031 do not apply to that exchange.

The Court also made extensive comparisons to the facts in Teruya Bros., Ltd. & Subs. v. Commissioner, 124 T.C. 45 (2005). In Teruya Bros., the Court said that "Congress concluded that if a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect, ‘cashed out' of the investment, and the original exchange should not be accorded nonrecognition treatment." The Tax court explained section 1031(f)(4) as reflecting Congress's concern that related persons not be able to circumvent the purposes of section 1031(f)(1) by interposing an exchange with an unrelated third party, concluding that the described transaction was the economic equivalent of a direct exchange of properties between a taxpayer and a related person, followed by the related person's sale of that property to an unrelated third party. The use of a qualified intermediary in the transactions was not permitted to insulate the end result. Since the attempted exchange and sale in Teruya exchange was regulated by section 1031(f)(1), the Tax court then ascertained whether the principal purposes of the deemed exchange was avoidance of Federal tax and concluding it was. "The economic substance of the transactions remains that the investments in … [the relinquished properties] were cashed out immediately and ... [the related person] ended up with the cash proceeds."

The Internal Revenue Service had imposed an accuracy-related penalty equal to 20 percent of the portion of any underpayment of tax pursuant to Section 6662(a) and the Tax Court set that penalty aside after determining that the taxpayer here had reasonably relied on professional advice in good faith. The lesson to be learned as a result of this decision of the Tax Court, is that if a taxpayer wishes to operate outside of the safe harbor created by the regulations and revenue procedures, a careful analysis of the relevant rulings, cases, regulations and the statute itself are mandatory. If any serious question remains, a private letter ruling may well be in order.

Code Section 1031 and its regulations make reference to Internal Revenue Code Section 267 and Internal Revenue Code Section 707(b)(1) to define who is a related party. We summarize these sections for convenience and follow the summary with the text of the relevant parts of these Sections.

Related Parties Summary

1.      Members of a family,

a. brothers and sisters (whether by the whole or half blood),
b. spouse,
c. ancestors, and
d. lineal descendants;

2.      An individual and a corporation that they directly, or indirectly, own more than 50 percent of the outstanding stock.

3.      Two corporations which are members of the same controlled group.

4.      A grantor and a Trustee of any trust.

5.      Trustees of different trusts, if the same person is a grantor of both trusts.

6.      A Trustee of a trust and its beneficiary.

7.      A Trustee of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts

8.      A Trustee of a trust and a corporation controlled by the Grantor.

9.      A person and a charitable organization which is controlled directly or indirectly by such person or by members of their family.

10.  A corporation and 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;

11.  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.

Controlled Corporations

The Ownership of Stock –

(1)   Stock shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries;

(2)   An individual shall be considered as owning the stock owned, directly or indirectly, by or for his family;

(3)   An individual owning (otherwise than by the application of paragraph (2)) any stock in a corporation shall be considered as owning the stock owned, directly or indirectly, by or for his partner;

(4)   Stock constructively owned by a person by reason of the application of paragraph (1) shall, for the purpose of applying paragraph (1), (2), or (3), be treated as actually owned by such person, but stock constructively owned by an individual by reason of the application of paragraph (2) or (3) shall not be treated as owned by him for the purpose of again applying either of such paragraphs in order to make another the constructive owner of such stock.

Internal Revenue Code Section 267.

Losses, expenses, and interest with respect to transactions between related taxpayers

    (a) In general

      (1) Deduction for losses disallowed

        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.

      (2) Matching of deduction and payee income item in the case of expenses and interest

        If -

          (A) by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not (unless paid) includible in the gross income of such person, and

          (B) at the close of the taxable year of the taxpayer for which (but for this paragraph) the amount would be deductible under this chapter, both the taxpayer and the person to whom the payment is to be made are persons specified in any of the paragraphs of subsection (b), then any deduction allowable under this chapter in respect of such amount shall be allowable as of the day as of which such amount is includible in the gross income of the person to whom the payment is made (or, if later, as of the day on which it would be so allowable but for this paragraph).  For purposes of this paragraph, in the case of a personal service corporation  (within the meaning of section 441(i)(2)), such corporation and any employee-owner (within the meaning of section 269A(b)(2), as modified by section 441(i)(2)) shall be treated as persons specified in subsection (b).

      (3) Payments to foreign persons

The Secretary shall by regulations apply the matching principle of paragraph (2) in cases in which the person to whom the payment is to be made is not a United States person.

    (b) Relationships

      The persons referred to in subsection (a) are:

(1) Members of a family, as defined in subsection (c)(4);

(2) 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;

(3) Two corporations which are members of the same controlled group (as defined in subsection (f));

(4) A grantor and a fiduciary of any trust;

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

(6) A fiduciary of a trust and a beneficiary of such trust;

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

(8) 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;

(9) A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) 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;

(10) A corporation and a partnership if the same persons own -

(A) more than 50 percent in value of the outstanding stock of the corporation, and

(B) more than 50 percent of the capital interest, or the profits interest, in the partnership;

(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;

(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; or

(13) 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.

(c) Constructive ownership of stock

For purposes of determining, in applying subsection (b), the ownership of stock –

(1)   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;

(2)   An individual shall be considered as owning the stock owned, directly or indirectly, by or for his family;

(3)   An individual owning (otherwise than by the application of paragraph (2)) any stock in a corporation shall be considered as owning the stock owned, directly or indirectly, by or for his partner;

(4)   The family of an individual shall include only his brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants; and

(5)   Stock constructively owned by a person by reason of the application of paragraph (1) shall, for the purpose of applying paragraph (1), (2), or (3), be treated as actually owned by such person, but stock constructively owned by an individual by reason of the application of paragraph (2) or (3) shall not be treated as owned by him for the purpose of again applying either of such paragraphs in order to make another the constructive owner of such stock.

(d) Amount of gain where loss previously disallowed

If –

(1)   in the case of a sale or exchange of property to the taxpayer a loss sustained by the transferor is not allowable to the transferor as a deduction by reason of subsection (a)(1) (or by reason of section 24(b) of the Internal Revenue Code of 1939); and

(2)   after December 31, 1953, the taxpayer sells or otherwise disposes of such property (or of other property the basis of which in his hands is determined directly or indirectly by reference to such property) at a gain, then such gain shall be recognized only to the extent that it exceeds so much of such loss as is properly allocable to the property sold or otherwise disposed of by the taxpayer. This subsection applies with respect to taxable years ending after December 31, 1953. This subsection shall not apply if the loss sustained by the transferor is not allowable to the transferor as a deduction by reason of section 1091 (relating to wash sales) or by reason of section 118 of the Internal Revenue Code of 1939.

(e) Special rules for pass-thru entities

(1) In general

In the case of any amount paid or incurred by, to, or on behalf of, a pass-thru entity, for purposes of applying subsection (a)(2) –

(A)  such entity,

(B)   in the case of - (i) a partnership, any person who owns (directly or indirectly) any capital interest or profits interest of such partnership, or (ii) an S corporation, any person who owns (directly or indirectly) any of the stock of such corporation,

(C)  any person who owns (directly or indirectly) any capital interest or profits interest of a partnership in which such entity owns (directly or indirectly) any capital interest or profits interest, and

(D)  any person related (within the meaning of subsection (b) of this section or section 707(b)(1)) to a person described in subparagraph (B) or (C), shall be treated as persons specified in a paragraph of subsection (b). Subparagraph (C) shall apply to a transaction only if such transaction is related either to the operations of the partnership described in such subparagraph or to an interest in such partnership.

(2) Pass-thru entity For purposes of this section, the term ''pass-thru entity'' means -            

(A) a partnership, and

(B) an S corporation.

(3)   Constructive ownership in the case of partnerships For purposes of determining ownership of a capital interest or profits interest of a partnership, the principles of subsection (c) shall apply, except that –

(A)  paragraph (3) of subsection (c) shall not apply, and

(B)   interests owned (directly or indirectly) by or for a C corporation shall be considered as owned by or for any shareholder only if such shareholder owns (directly or indirectly) 5 percent or more in value of the stock of such corporation.

(4)   Subsection (a)(2) not to apply to certain guaranteed payments of partnerships In the case of any amount paid or incurred by a partnership, subsection (a)(2) shall not apply to the extent that section 707(c) applies to such amount.

(5)   Exception for certain expenses and interest of partnerships owning low-income housing

(A)   In general This subsection shall not apply with respect to qualified expenses and interest paid or incurred by a partnership owning low-income housing to - (i) any qualified 5-percent or less partner of such partnership, or (ii) any person related (within the meaning of subsection (b) of this section or section 707(b)(1)) to any qualified 5-percent or less partner of such partnership.

(B)   Qualified 5-percent or less partner For purposes of this paragraph, the term ''qualified 5-percent or less partner'' means any partner who has (directly or indirectly) an interest of 5 percent or less in the aggregate capital and profits interests of the partnership but only if - (i) such partner owned the low-income housing at all times during the 2-year period ending on the date such housing was transferred to the partnership, or (ii) such partnership acquired the low-income housing pursuant to a purchase, assignment, or other transfer from the Department of Housing and Urban Development or any State or local housing authority. For purposes of the preceding sentence, a partner shall be treated as holding any interest in the partnership which is held (directly or indirectly) by any person related (within the meaning of subsection (b) of this section or section 707(b)(1)) to such partner.

(C)   Qualified expenses and interest

For purpose of this paragraph, the term ''qualified expenses and interest'' means any expense or interest incurred by the partnership with respect to low-income housing held by the partnership but –

(i)  only if the amount of such expense or interest (as the case may be) is unconditionally required to be paid by the partnership not later than 10 years after the date such amount was incurred, and

(ii)  in the case of such interest, only if such interest is incurred at an annual rate not in excess of 12 percent.

(D)   Low-income housing

For purposes of this paragraph, the term ''low-income housing'' means –

(i) any interest in property described in clause (i), (ii), (iii), or (iv) of section 1250(a)(1)(B), and

(ii) any interest in a partnership owning such property.

(6)   Cross reference For additional rules relating to partnerships, see section 707(b).

(f) Controlled group defined; special rules applicable to controlled groups

(1)   Controlled group defined

For purposes of this section, the term ''controlled group'' has the meaning given to such term by section 1563(a), except that –

(A)  ''more than 50 percent'' shall be substituted for ''at least 80 percent'' each place it appears in section 1563(a), and

(B)   the determination shall be made without regard to subsections (a)(4) and (e)(3)(C) of section 1563.

(2)   Deferral (rather than denial) of loss from sale or exchange between members

In the case of any loss from the sale or exchange of property which is between members of the same controlled group and to which subsection (a)(1) applies (determined without regard to this paragraph but with regard to paragraph (3)) - (A) subsections (a)(1) and (d) shall not apply to such loss, but (B) such loss shall be deferred until the property is transferred outside such controlled group and there would be recognition of loss under consolidated return principles or until such other time as may be prescribed in regulations.

(3)   Loss deferral rules not to apply in certain cases

(A)   Transfer to DISC

For purposes of applying subsection (a)(1), the term ''controlled group'' shall not include a DISC.

(B)   Certain sales of inventory

Except to the extent provided in regulations prescribed by the Secretary, subsection (a)(1) shall not apply to the sale or exchange of property between members of the same controlled group (or persons described in subsection (b)(10)) if –

(i) such property in the hands of the transferor is property described in section 1221(a)(1),

(ii) such sale or exchange is in the ordinary course of the transferor's trade or business,

(iii) such property in the hands of the transferee is property described in section 1221(a)(1), and

(iv) the transferee or the transferor is a foreign corporation.

(C)   Certain foreign currency losses

To the extent provided in regulations, subsection (a)(1) shall not apply to any loss sustained by a member of a controlled group on the repayment of a loan made to another member of such group if such loan is payable in a foreign currency or is denominated in such a currency and such loss is attributable to a reduction in value of such foreign currency.

(4)   Determination of relationship resulting in disallowance of loss, for purposes of other provisions

For purposes of any other section of this title which refers to a relationship which would result in a disallowance of losses under this section, deferral under paragraph (2) shall be treated as disallowance.

(g) Coordination with section 1041 Subsection (a)(1) shall not apply to any transfer described in section 1041(a) (relating to transfers of property between spouses or incident to divorce).

Internal Revenue Code Section 707(b)(1).

(b) Certain sales or exchanges of property with respect to controlled partnerships

(1)   Losses disallowed

No deduction shall be allowed in respect of losses from sales or exchanges of property (other than an interest in the partnership), directly or indirectly, between –

(A)  a partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest, or the profits interest, in such partnership, or

(B)   two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests. In the case of a subsequent sale or exchange by a transferee described in this paragraph, section 267(d) shall be applicable as if the loss were disallowed under section 267(a)(1). For purposes of section 267(a)(2), partnerships described in subparagraph (B) of this paragraph shall be treated as persons specified in section 267(b).


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