It certainly sounds like a grand plan.  There is, however one small catch - Code Sec. 267 specifically disallows losses on sales to related parties.

Why is that, you ask?  There is simply too huge a potential for abuse.  Think for a moment of the opportunity you might have to totally write off a piece of property - let's say the family farm in this case - simply be "selling it" continually between family members at a loss.

For example, Taxpayer A owns a farm that he inherited from his uncle and has no intention of ever allowing it to leave the family.  His inherited basis in the property is $300,000, but he decides to "sell" it to his brother for $200,000 and thereby, gain himself a $100,000 tax write-off.  After several years, his brother "decides he no longer wants it" and sells it back to Taxpayer A for $100,000 gaining himself another $100,000 write-off!

Sound too good to be true?  Well, obviously it is.  The Tax Courts have thrown out so many related party loss deductions over the years that it would likely be a waste of legal fees to even challenge the IRS on this issue.  Section 267 not only applies to family members, but also includes related businesses, trusts, fiduciaries, etc as defined below:

• Members of a family, including brothers and sisters, spouse, ancestors (e.g., parents, grandparents), and lineal descendents (children, grandchildren).
  
• An individual and a corporation where more than 50% of the stock is owned directly or indirectly by that individual. (Indirectly means, for example, that stock owned by your children can be deemed owned by you.)
  
• Two corporations which are members of the same controlled group (e.g., common stock ownership).
  
• Certain relationships between trusts, grantors, fiduciaries and beneficiaries of such trusts.
  
• A corporation and a partnership if the same persons own more than 50% of the stock of the corporation and more than 50% of the profits or capital interest of the partnership.
  
• An S corporation and another S corporation if the same persons own more than 50% of the stock of each corporation or an S corporation and a C (regular) corporation if the same persons own more than 50% of the stock in each.

There are related parties other than the ones listed above as well.  What exactly constitutes a related party can sometimes be a gray area and you should certainly contact us first if you think there may be some risk to a particular transaction you are planning.

One particular rule that often trips up our clients is the "constructive ownership rule."  Basically, that rule stipulates that any ownership interest (stock, etc) held by a related party to the taxpayer is "attributed" to the taxpayer.  

For example, Taxpayer A only owns 10% of the stock in a particular company, but his brothers and sisters own another 30% and his mother owns 40%.  Therefore, any transaction between Taxpayer A and the corporation will likely be subject to the related party rules even though Taxpayer A only owns 10% of the corporation stock.  The constructive ownership rule attributes another 70% of the stock to him through his parents and siblings.

We often advise our clients to avoid related party transactions at all times if possible.  There are enough negative consequences to related party transactions that they are rarely advisable.  A gain on a related party transaction is generally recognized, but losses are not.  That means if you sell numerous items to a related party, all of the "gain" items are added up and reported on your tax return, but all of the "loss" items are not.  They cannot be netted.

Also, the disallowed loss on a related party transaction isn't always recaptured upon a subsequent sale by the other party.  For example, if you own shares of Company X with a $20,000 basis and you sell those shares to your sister for $10,000, you obviously cannot take the $10,000 loss you incurred under the related party rules. 

If your sister then sells the shares for $30,000, she will recognize only the $10,000 gain between your $20,000 basis and her $30,000 proceeds.  However, if she later sells the shares for only $5,000, her loss will only be the difference between the $10,000 she paid you and the $5,000 in proceeds.  The $10,000 you lost on the sale to her will never be deducted by either of you!

Of course, we do have clients who think they have figured out a way around the related party rules.  They simply sell a piece of property to an unrelated party (a friend for example) who then turns around and re-sells the property to the related party.  Unfortunately, that doesn't work.  Sec. 267 also applies to "indirect" transfers.  The IRS will simply "look through" the transaction and disallow the loss.

And what happens if the friend in the example above doesn't re-sell the property to a related property?  Well, the related party rules can still bite you if the IRS deems that the price appears to be artificially low and could not reasonable have been an "arm's length" transaction.  Yes, even friends can be related parties if the deal looks suspicious.

As you can see, there are a lot of "traps" in the related party rules.  We encourage you to call our office if you are considering a transaction that could even remotely be considered a related party transaction.