Section 267(b): Related Party Transaction Rules

Section 267 of the Internal Revenue Code establishes rules to prevent taxpayers from generating artificial losses or shifting income through transactions with closely connected individuals or entities. These provisions are designed to stop taxpayers from claiming tax benefits on transactions where their economic position has not meaningfully changed. This article focuses on Section 267(b), which defines these relationships, and explores the tax consequences that arise from them.

Defining Related Parties

Section 267(b) provides a detailed list of relationships that are considered “related” for tax purposes. These include:

• Family members, which includes an individual’s spouse, siblings (including half-siblings), ancestors, and lineal descendants. Relationships by marriage, such as in-laws, are not included, but legally adopted children are treated as blood relatives.
• An individual and a corporation where that individual owns more than 50% of the value of the company’s outstanding stock. This rule prevents a majority shareholder from selling a depreciated asset to their own company to recognize a personal tax loss while still controlling the asset.
• Two corporations that are members of the same controlled group.
• A trust’s grantor and its fiduciary; a fiduciary and a beneficiary; fiduciaries of two trusts with the same grantor; and a fiduciary and a corporation if the trust or grantor owns over 50% of the stock.
• A corporation and a partnership if the same people own more than 50% of the corporation’s stock and more than 50% of the capital or profit interest in the partnership.
• Two S corporations if the same individuals own more than 50% of the stock in each.
• An executor of an estate and a beneficiary of that estate.

Constructive Ownership Rules

To apply the related party definitions, one must understand the constructive ownership rules under Section 267(c). These rules treat a taxpayer as owning stock that is owned by others, aggregating ownership interests to determine if the more-than-50% control threshold has been met.

The first principle is family attribution, where an individual is considered to own stock owned by their family members, as defined previously. For example, if a taxpayer owns 20% of a company and their spouse owns 35%, the taxpayer is treated as constructively owning 55%, triggering the related party rules.

Another rule is entity-to-owner attribution. Stock owned by a corporation, partnership, estate, or trust is treated as being owned proportionately by its shareholders, partners, or beneficiaries. For example, if an individual owns 50% of a partnership that owns 40% of a corporation’s stock, the individual is deemed to own 20% of that stock. This attributed ownership is then added to any stock the individual owns directly or through family attribution.

Partner-to-partner attribution also exists. For an individual to be treated as owning stock held by their business partner, that individual must already own some stock in the same corporation. If the individual has no existing ownership stake, their partner’s shares are not attributed to them.

Tax Consequences of Related Party Transactions

Transactions between related parties face two primary tax consequences under Section 267(a). The first is the disallowance of losses. Any loss realized from the sale or exchange of property between related parties is not deductible by the seller.

For example, if an individual sells stock with a tax basis of $15,000 to their sister for its fair market value of $10,000, a $5,000 loss is realized. Because the transaction is between related parties, the $5,000 loss is disallowed and cannot be used to offset other capital gains.

The second consequence is the matching of deductions and income, which affects related parties using different accounting methods. When an accrual-method payer owes an expense to a cash-method payee, the payer cannot deduct the expense until the day the payment is made and the payee includes it in their gross income.

This matching principle prevents a timing mismatch. For example, an accrual-basis corporation could otherwise deduct a year-end bonus for its cash-basis majority shareholder in the current year, while the shareholder would not report the income until the following year. The rule defers the corporation’s deduction until the shareholder receives the cash and recognizes the income.

The Subsequent Sale Rule

While a loss on a sale to a related party is initially disallowed, it may not be permanently lost. Under Section 267(d), if the related party who acquired the property later sells it to an unrelated third party, the previously disallowed loss can be used to reduce any gain recognized on the subsequent sale.

For example, a sister sold stock with a $15,000 basis to her brother for $10,000, and her $5,000 loss was disallowed. The brother’s basis in the stock is his $10,000 purchase price. If the brother later sells that stock to an unrelated person for $18,000, he realizes an $8,000 gain.

Under the subsequent sale rule, the brother can use his sister’s previously disallowed $5,000 loss to offset his gain. This reduces his taxable gain from $8,000 down to $3,000. This provision acknowledges that a real economic loss was incurred within the family unit and allows it to be recognized when the asset finally leaves the related group.

The disallowed loss can only be used to reduce a gain; it cannot be used to create or increase a loss on the subsequent sale. If the brother had sold the stock for $9,000, he would have a $1,000 loss, and the sister’s original disallowed loss of $5,000 would be permanently lost.