Anti-Churning Rules for Related Party Transactions

Churning is the practice of selling or transferring an asset to a related individual or company primarily to obtain a more favorable tax position. This often involves transactions designed to create a higher basis in an asset for depreciation purposes without any meaningful change in who controls or benefits from that asset. The anti-churning rules, found within the U.S. Internal Revenue Code, are regulations designed to prevent this practice. These rules identify transactions that lack genuine economic substance and disallow the associated tax benefits, preserving the integrity of depreciation schedules. By stopping taxpayers from artificially converting assets ineligible for modern, more accelerated cost recovery methods into eligible assets, the rules ensure that tax deductions reflect economic reality.

Purpose and Scope of Anti-Churning Rules

The purpose of the anti-churning rules is to prevent taxpayers from converting existing assets into property that can be written off under current, more generous tax provisions. Before tax law changes in the 1980s and 1990s, many assets had less favorable depreciation schedules, and certain intangibles like goodwill could not be amortized at all. The rules were established to stop taxpayers from selling these older assets to a related entity to make them eligible for newer, faster deductions without a true change in economic position.

These regulations primarily target two broad categories of property. The first is tangible property, such as equipment or buildings, depreciated using the Modified Accelerated Cost Recovery System (MACRS). The second is intangible assets, like goodwill or trademarks, amortized under Section 197 of the Internal Revenue Code. For tangible property, the key date is 1987; assets in service before then fall under older systems. For Section 197 intangibles, the period is between July 25, 1991, and August 10, 1993.

Identifying a Related Party

The anti-churning rules apply only to transactions between a “related party,” a term the Internal Revenue Code defines broadly to capture relationships where a transfer might not represent a true change in economic interest. These relationships extend beyond direct family ties to include corporate and partnership structures.

Family relationships are a primary focus. The rules consider the following as related parties:

• An individual’s spouse
• Siblings
• Children and grandchildren
• Parents and grandparents

This prevents a parent, for example, from selling old equipment to their child’s business, which would then try to depreciate the asset anew based on the higher purchase price.

Ownership-based relationships are also closely scrutinized, such as a transaction between an individual and a corporation where that individual owns more than a certain percentage of the stock. While a 50% ownership stake is a common threshold, the anti-churning rules for intangibles use a lower threshold of 20% to define control. Entity-based relationships include transactions between two corporations that are members of the same controlled group, such as a parent company and its subsidiary. A partnership and one of its partners who owns a significant interest in the partnership’s capital or profits are also considered related.

Application to Tangible Property

When applied to tangible property like machinery or buildings, the anti-churning rules test whether the property was owned or used by the taxpayer or a related party at any point during 1986. If this condition is met and the asset is subsequently sold to a related party, the provisions are triggered. This prevents the buyer from using the more accelerated depreciation methods available under the Modified Accelerated Cost Recovery System (MACRS).

The consequence is a significant reduction in potential tax deductions. Instead of calculating depreciation under MACRS, the new owner is forced to use an older, less advantageous method. In many cases, the buyer must continue using the same depreciation method the seller was using, or one that is no more accelerated.

For example, a father owns a manufacturing business with a machine placed in service in 1985. In the current year, he sells this machine to a new corporation wholly owned by his son. Because the son is a related party and the machine was used by the father’s business in 1986, his son’s corporation cannot use MACRS and must instead use a depreciation method no more accelerated than the one the father used.

Application to Intangible Assets

The anti-churning rules for intangible assets are governed by Section 197 and apply to assets such as goodwill, customer lists, and trademarks. The purpose is to prevent the amortization of intangibles that were not amortizable before the enactment of Section 197 in 1993. This stops taxpayers from creating a 15-year amortization deduction by selling a previously non-amortizable asset to a related entity.

The test for these assets centers on a “transition period” from July 25, 1991, to August 10, 1993. If an intangible asset was held or used by the taxpayer or a related party during this timeframe, it is classified as a “pre-enactment” intangible. If such an asset is later acquired from that related party, it becomes ineligible for the 15-year amortization provided by Section 197.

For example, an individual started a business in 1990, creating significant goodwill. In the current year, she sells the business, including the goodwill, to a new corporation in which she owns a 60% stake. Because she is a related party and held the goodwill during the 1991-1993 transition period, the corporation is barred from amortizing the value allocated to that goodwill.

Exceptions and Special Considerations

While the anti-churning rules are broad, there are specific situations where they do not apply. A significant exception involves property acquired from a decedent. When an individual inherits an asset, whether tangible or intangible, the anti-churning rules are waived. This allows the heir to treat the property as if it were newly acquired, making it eligible for current depreciation under MACRS or amortization under Section 197, based on its fair market value at the time of death. This exception is based on the principle that a transfer due to death is not a transaction motivated by tax avoidance but is an involuntary, true change in ownership.

It is also important to recognize the existence of a general anti-abuse rule. This provision grants the IRS the authority to disallow depreciation or amortization on an asset even if the transaction does not technically fall within the specific related-party definitions. If a transaction is structured with the principal purpose of avoiding the anti-churning rules, the IRS can apply the rules based on its substance.