Normal tax rules are suspended in the case of certain sales between related parties. Related party sales generally create negative tax consequences for sellers including recharacterizing capital gains as ordinary income, denying installment sales reporting, disallowing realized losses and restricting the use of like-kind exchanges.
Most business people believe that they have a pretty good understanding of how the tax law operates from a big picture perspective. Sales of property held for more than a year generate preferentially taxed capital gains, realized losses can be offset against realized gains, sales spanning more than one year can be reported on the installment basis, realized losses can be offset against realized gains and like kind property can be exchanged on a tax-free basis. So it is with great surprise that these same smart business people learn (sometimes after the fact because they fail to consult with their tax advisors) that the “normal rules” do not apply when the sales involve related parties.
The purpose of this and the next postings is to discuss the special provisions that automatically apply to generate negative tax consequences when certain types of property are sold between related parties.
Part 1 – Gain on Appreciated Property May Be Converted to Ordinary Income
Taxpayer’s often sell appreciated property between (or to) their closely held businesses at the property's fair market value. However, even if the price is set at arm's length, based on an independent appraisal, the sale can cause extremely harsh income tax consequences to the uninformed seller.
Gain on the sale of depreciable real property held for more than one year may be subject to three different tax rates:
- Depreciation recapture is taxed as ordinary income at a maximum rate of 35%;
- Unrecaptured §1250 gain is taxed at a maximum rate of 25%; and
- Long-term capital gain taxed at a maximum rate of 15%.
In addition, a special punitive rule applies to convert gain otherwise taxable as capital gain to ordinary income. If the property sold or exchanged (a liquidation is treated as a sale) between related parties is depreciable by the buyer (regardless of whether the property was depreciable by the seller), § 1239 requires any gain recognized on the sale or exchange to be treated as ordinary income. This rule applies to property that can be depreciated by the buyer, regardless of whether the seller could depreciate the asset (see Rev. Rul. 60-302). The gain will be ordinary even if the purchaser chooses not to depreciate the asset or elects to use an alternative method of expensing (e.g., amortization) (see Treasury Reg. § 1.1239-1(a)). If a sale or exchange includes depreciable and nondepreciable property, the gain is allocated between the properties and only the gain allocable to the depreciable property results in ordinary income.
Whether persons are related is determined based on their relationship at a certain time, depending on who sells the property [Treasury Reg. § 1.1239-1(c)(3) and (4)]:
- If a corporation is the seller, the determination is made either immediately before or after the sale.
- If an individual sells the property, the determination is made immediately after the transfer.
- If the sale is between two controlled entities, the parties must be related immediately before and after the sale for § 1239 to apply.
This special rule recharacterizing capital gain to ordinary income applies above and beyond the §§ 1245 and 1250 ordinary income depreciation recapture rules that may also apply to gains from the sale or exchange of depreciable property. The selling taxpayer first applies the ordinary income recapture rules of §§ 1245 and 1250. To the extent there is gain beyond the amount treated as ordinary under the recapture rules, that gain is also ordinary if § 1239 applies.
The following are related parties for the § 1239 ordinary income rules.
- A taxpayer and all controlled entities;
- A taxpayer and any trust of which the taxpayer or the taxpayer's spouse is a beneficiary (unless the beneficiary's interest is a remote contingent interest).
- An executor of an estate and a beneficiary of the estate, except for sales or exchanges to satisfy pecuniary (dollar amount) bequests.
- An employer, or a person related to the employer, and a welfare benefit fund controlled by the employer or the related person.
Controlled entities include the following:
- A corporation in which the taxpayer owns (directly or indirectly) more than 50% of the outstanding stock by value.
- A partnership in which the taxpayer owns (directly or indirectly) more than 50% of the capital or profits interest.
- A corporation and another corporation that is a member of the same controlled group. Under this definition, a parent corporation and a more than 50% owned subsidiary are members of a controlled group. The same is true for brother/sister corporations with more than 50% common ownership in the hands of five or fewer shareholders (considering only identical ownership in each corporation).
- A corporation and a partnership, if the same taxpayers own more than 50% of the outstanding stock (by value) of the corporation and more than 50% of the capital or profits interest in the partnership.
- Two S corporations, if the same taxpayers own more than 50% of the outstanding stock (by value) of each corporation.
- An S corporation and a C corporation, if the same taxpayers own more than 50% of the outstanding stock (by value) of each corporation.
In defining related parties under these rules, the following § 267(c) constructive stock ownership rules apply, except an individual is not considered to own the stock of his partner (§ 1239(c)(2)):
- Stock owned directly or indirectly by or for a corporation, partnership, estate, or trust is considered owned proportionately by or for its shareholders, partners, or beneficiaries.
- An individual is considered to own stock owned directly or indirectly by or for members of his family. Family means brothers and sisters (including half brothers and sisters), spouses, ancestors (father, mother, grandfather, grandmother, and so on), and lineal descendants (son, daughter, grandson, granddaughter, and so on).
- An individual owning (other than through constructive ownership by family members as described in (2)) any stock of a corporation is considered to own the stock owned directly or indirectly by or for his partner.
- To prevent endless recycling of the constructive ownership concept, stock that is constructively owned because of rule (1) is considered actually owned for purposes of applying rules (1), (2), and (3). to a taxpayer. However, stock considered constructively owned because of applying rule (2) or (3) is not considered actually owned for purposes of again applying rule (2) or (3) to make another taxpayer the constructive owner of stock (see § 267(c)(5).
Important Planning: It is important to note that sales of depreciable property at a gain between individuals are not covered by this rule. The related party rules apply to sales involving related business entities.
Ordinary Income Rule for Partners and Partnerships
Under § 707(b)(2), ordinary income is recognized on any gain from a sale or exchange of property that is not a capital asset between a partnership and the owner (directly or indirectly) of a more than 50% capital or profits interest in the partnership. Whether an asset is a capital asset is determined by its status in the hands of the buyer. Although this rule is similar to the § 1239 rule that converts capital gain on the sale of depreciable property to certain related parties, the § 707(b)(2) rule can apply to both depreciable and nondepreciable property, such as land used for business purposes.
The § 707(b)(2) rule also applies to sales between two partnerships that are more than 50% owned by the same persons. More than 50% ownership means direct or indirect ownership of more than 50% of the capital or profits interests in both partnerships. Section 707(b)(3) imposes constructive partnership interest ownership rules that are the same as the rules for constructive ownership of stock discussed above, except an individual is not considered to own the partnership interest owned by his partner. Thus, the § 707(b)(2) capital gain disallowance rule can be triggered by constructive ownership rules that create more than 50% ownership in a partnership.
The following example illustrates how the gain recharacterization rule can generate negative consequences for the unsuspecting taxpayer.
Example: Taxpayer owns apartment buildings with a basis of $1 million, which he actively rents and manages. To bring his adult children into the rental business, taxpayer establishes a limited partnership that will purchase the apartment building for its fair market value. Taxpayer will retain only 10% of the partnership and his adult children will own the other 90%. Taxpayer obtains an independent appraisal of the property which determines the property’s fair market value is $10 million. The partnership purchases the property using a 10-year installment obligation (i.e., the $10 million sales price will be paid in equal payments of $1 million per year for 10 years). There is no depreciation recapture associated with the property.
When there is a sale of depreciable property between related parties, both §§ 1239 and 707(b)(2) may recharacterize gain as ordinary income. Under § 1231, gain from the sale of an apartment building used in a trade or business and held for more than one year is generally long-term capital gain (to the extent the gain does not constitute unrecaptured 1250 gain). Long-term capital gains are taxed to individuals at a current maximum rate of 15%, while ordinary income is taxed at rates of up to 35%. If Taxpayer had sold the apartment buildings to an unrelated third party, he would be taxed on any gain from the sale at capital gains rates (and/or the alternative 25% rate that applies to unrecaptured 1250 gains). However, because the sale in this example is between Taxpayer and a controlled entity, § 1239 recharacterizes any capital gain as ordinary income. Although Taxpayer owns directly only 10% of the partnership, Taxpayer is deemed to own the other 90% of the partnership owned by his adult children under the constructive ownership rules. As a result, the partnership is considered a controlled entity.
Section 1239(a) applies only if the property is subject to the allowance for depreciation provided in § 167 in the hands of the transferee. Because the apartment buildings will be depreciable by the partnership, Taxpayer’s gain is taxed partly as ordinary income. The portion of the gain attributable to the land is not subject to § 1239 and is taxed as a capital gain.
Although the gain attributable to the land escapes taxation as ordinary income under § 1239, another provision recharacterizes the entire gain on Taxpayers' sale to the partnership from capital gain to ordinary income. Section 707(b) provides that any gain recognized on the sale or exchange of certain property between a partnership and a partner owning, directly or indirectly, more than 50% of the capital or profits interest of the partnership is ordinary income. The same constructive ownership rules that are in effect for § 1239 also apply under § 707(b); as a result a person is treated as the owner of a partnership interest when the interest is in fact owned by a related individual or entity.
The recharacterization under § 707(b)(2) applies only if the property, in the hands of the transferee, is not a capital asset. Neither real property, nor property subject to the allowance for depreciation, is a capital asset if used in a trade or business. Whether a rental activity is a trade or business is generally a question of fact. If the partnership’s activities with respect to its rental activities of the apartments are so minimal so as not to rise to the level of a trade or business, the property may be a capital asset, with the result that § 707(b)(2) would not recharacterize gain to ordinary income. On the other hand, if the rental activities are a trade or business, Taxpayer’s entire gain on the sale of the property to the partnership would be taxed as ordinary income under § 707(b)(2).
Section 707(b)(2) is much broader than § 1239 since it also covers property that is not depreciable, such as inventory and land. Section 707(b)(2) often can be easily avoided thereby reducing the amount of gain recharacterized to ordinary. For example, if Taxpayer had sold the apartment buildings to a related corporation instead of to a partnership, § 707(b)(2) would not apply. Instead, § 1239 would be the applicable provision and would recharacterize as ordinary income only the gain allocable to the buildings.
To avoid § 1239 altogether, Taxpayer could have sold the apartment building directly to his adult children to operate as tenants in common. However, this type of “restructuring” is complex and should be done only after careful consideration of all of the risk factors.
In Part 2, we look at the rule that prohibits the use of the installment method if the transaction involves the sale of depreciable property to a related party. If this rule applies, the entire gain is taxable in the year of sale.
In Part 3, we address yet another prohibition on the use of the installment sales method; the second disposition rule.