Tax Challenges With Related Party Sales: Navigating Complex IRS Rules for Closely Held Businesses Defining Related Parties and Applying Rules for Capital Gain Treatment, Installment Reporting, Disallowed Losses

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Matthew Donnelly, Esq., Skadden Arps, Washington, D.C.

Yoram Keinan, Partner and Chair, Tax Department, Carter Ledyard & Milburn, New York

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Tax Challenges With Related Party Sales: Navigating Complex IRS Rules

for Closely Held Businesses

Presenters

• Matthew Donnelly, Skadden Arps, Washington, D.C.

• Yoram Keinan, Partner and Chair, Tax Department Carter Ledyard & Milburn, New York

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Yoram Keinan

• Yoram Keinan, 212-238-8790 (keinan@clm.com) • Yoram Keinan is the chair of the tax department

at Carter, Ledyard & Milburn LLP in New York. With more than fifteen years of experience in tax law both in the United States and Israel, Yoram Keinan focuses on U.S. and international taxation of financial products and institutions and represents major banks and investment firms. Prior to joining Carter Ledyard & Milburn LLP, Yoram Keinan served as a shareholder at Greenberg Traurig’s Tax Department in New York. 7

Matthew Donnelly

• Matthew Donnelly, (202) 371-7236 (matthew.donnelly@skadden.com)

• Matt is an associate at Skadden Arps in Washington, DC, where his practice focuses on the domestic and international tax aspects of mergers, acquisitions, dispositions, joint ventures, restructurings and financings.

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Overview

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Related Party Transactions

• Disallow Losses on Sales or Exchanges of Property between Related Parties

• Re-characterization of Gain on Sale of Depreciable Property between Related Parties.

• Limitations on Like Kind Exchanges

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Section 267: Limitations on Losses/Deductions in Transactions

between Related Parties

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Overview • Section 267(a)(1) disallows any loss from the sale or

exchange of property, directly or indirectly, between related persons specified in Section 267(b).

• Four loss “disallowance” rules – Note: Statute speaks in terms of loss “disallowance” –

which, in the Code, typically implies a permanently state – however the losses “disallowed” by section 267 may ultimately be utilized, albeit in some instance by another taxpayer

– Perhaps the most pervasive related-party rules in the Code – Affect numerous transactions – Applies to transactions conducted at arm’s length

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Section 267(a)(1): Loss Suspension/Transfer Rule • Disallows deduction in respect of any loss from the sale or exchange of

property, directly or indirectly, between related persons (as defined in 267(b))

– Exceptions: (i) losses (of the transferor or transferee) recognized as a result of distributions by a corporation in complete liquidation, and (ii) transfers of property between spouses or incident to divorce

• If section 267(a)(1) applies and the transferee later sells or otherwise disposes of such property at a gain (or of other property the basis of which in his hands is determined directly or indirectly by reference to such property), 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 transferee

– Does not apply if the loss sustained by the transferor is not allowable to the transferor as a wash sale under section 1091

– Suspended loss transfers only to original transferee, not subsequent transferees (e.g., donee)

– Suspended loss tracked among divisible properties to which loss is attributable; if not possible, a portion assigned to property based on proportionate FMV of part, item or class

• Note: Suspended loss not a basis adjustment; affects only gain, not loss

Section 267(a)(1): Examples • H sells to his wife, W, for $500, certain corporate stock with an adjusted basis

for determining loss to him of $800. The loss of $300 is not allowable to H by reason of section 267(a)(1) and paragraph (a) of §1.267(a)-1. W later sells this stock for $1,000. Although W's realized gain is $500 ($1,000 minus $500, her basis), her recognized gain under section 267(d) is only $200, the excess of the realized gain of $500 over the loss of $300 not allowable to H. In determining capital gain or loss W's holding period commences on the date of the sale from H to W.

• Alternatively, W later sells her stock for $300 instead of $1,000. Her recognized loss is $200 and not $500 since section 267(d) applies only to the nonrecognition of gain and does not affect basis.

• Alternatively, W transfers her stock as a gift to X. The basis of the stock in the hands of X for the purpose of determining gain, under the provisions of section 1015, is the same as W's, or $500. If X later sells the stock for $1,000 the entire $500 gain is taxed to him. Treas. Reg. § 1.267(d)-1(a)(4) Ex. 1-3.

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Section 267(a)(1): Suspense/Transfer Rule (cont.)

• Disallows deduction in respect of any loss from the sale or exchange of property, directly or indirectly, between related persons (as defined in 267(b), listed later)

• “Indirect” sale or exchange characterization has been employed successfully by the Service on several occasions to defer losses on sales or exchanges between unrelated parties but in which the taxpayer ultimately suffered no economic loss.

Section 267(a)(1): Case Law • Not always consistent and analysis must proceed carefully • “If there is a shift of property between those economically related

persons designated under section 267(b), then, regardless of the motive for and manner in which the intragroup transfer is accomplished, the resulting loss is disallowed under section 267(a)(1) unless there occurs a definite break in the continuity of the related group's economic interest in the transferred property so that the seller undoubtedly realizes a genuine substantive economic loss. In determining whether there is a genuine economic loss, the intent of the parties, the time element, the ultimate result, and the mutual interdependence of the steps taken as well as the selling price, the fair market value, and the near-identity of terms of the sale and purchase are among the factors to be considered.” Hassen v. Comm’r, 63 T.C. 175, 185 (1974).

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Section 267(a)(2): Deduction Matching Rule • If by reason of the method of accounting of a payment recipient, the amount thereof

is not (unless paid) includible in the gross income of such recipient, and at the close of the taxable year of the payor for which (but for 267(a)(2)) the amount would be deductible under this chapter, both the payor and the related person are 267(b) related persons, 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 recipient (or, if later, as of the day on which it would be so allowable but for this paragraph) – E.g., accrual method payor and related cash-method recipient – Includible, not included; constructive receipt doctrine often relevant – Does not apply to OID accruals (section 1272 puts holder on accrual method)

• Special relatedness rules apply to tiered pass-through entities (i.e., partnerships and S corporations)

• Does not apply to partnership guaranteed payments • Exclusions apply with respect to certain expenses paid or incurred by a partnership

owning low-income housing

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Section 267(a)(2): Deduction Matching (cont.)

• Note: Section 267(a)(2) can also defer the deduction of otherwise deductible cost recovery, depreciation or amortization – Situation arises with respect to amount owed to a related person for interest or

rent or for the performance or nonperformance of services if the payor capitalized the amount or treated as a deferred expense, e.g., amounts owed for acquisition, development, or organizational services or for covenants not to compete

• Note: The deduction is not allowable until the day as of which the amount is includible in the gross income of the person to whom payment of the amount is made, even though the relationship ceases to exist at an earlier time

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Section 267(a)/Section 707(b) Overlap • Section 267(b)(10) is the only relationship in 267(b) that includes a partnership

– Section 707(b) (discussed below) applies to sales or exchanges of property between partnerships and related persons

– Treats two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests as “related persons” within the meaning of section 267(b) for purposes of applying section 267(a)(2)

• Treas. Reg. § 1.267(b)-1(b) (1958) and Treas. Reg. § 1.267(a)-2T(c) (Answers 2 & 3) (1984) provide rules applicable to transaction between partnerships and related persons – Apply aggregate partnership principles to proportionately disallow losses in

transactions involving partnerships and persons not “related” under 267(b) – Legislative history of 1986 Act indicates Section 707(b) is intended to replace the

proportionate loss rules • One major treatise states that Treas. Reg. § 1.267(a)-2T(c) (Answers 2 & 3) are invalid

based on 1986 legislative history • Another prominent commentator has argued that Treas. Reg. § 1.267(b)-1(b) is invalid

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Section 267(a)(3): Foreign Payment Rule • Generally requires a taxpayer to use the cash method of accounting with respect to the

deduction of amounts owed to a related foreign person, i.e., an amount that is owed to a related foreign person and that is otherwise deductible may not be deducted by the taxpayer until such amount is paid to the related foreign person – Requires a change in method of accounting for such items – Consistent with treatment of OID in Section 163(e)(3)

• Applies to interest (U.S. or foreign source) as well as U.S.-source dividends, rents, salaries, wages and other FDAP income and certain gains – Excludes foreign-source income (other than interest) that is not effectively connected

with the conduct of a U.S. trade or business (ECI) • Exceptions:

– If payment is ECI to the payee, section 267(a)(2) rules apply – Payments (other than interest) exempt from tax under a treaty – For CFCs/PFICs, the amount is allowable as a deduction when paid unless such

amount is includible in the prior taxable year in the income of a U.S. person owning (within the meaning of section 958(a)) shares of the CFC/PFIC

Section 267(b): List of Related Parties • (1) Members of a family; • (2) An individual and a corporation if the individual holds more than 50% (value) of the stock; • (3) Two corporations which are members of the same controlled group; • (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% 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 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% in value of the outstanding stock of the corporation, and (B) more than 50% of the capital interest, or the profits interest, in the partnership;

• (11) An S corp and another S corp if the same persons own more than 50% (value) of the stock of each corp;

• (12) An S corp and a C corp, if the same persons own more than 50% (value) of the 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. 21

Section 267(c): Attribution Rules • In determining ownership of stock for purposes of section 267(b), 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. Section 267(c)(1).

• An individual is considered owning the stock owned, directly or indirectly, by or for his family. Section 267(c)(2).

• An individual owning any stock of a corporation is considered owning the stock owned, directly or indirectly, by or for his partner. Section 267(c)(3).

• The “family” of an individual includes his brothers/sisters (whole or half blood), spouse, ancestors, and lineal descendants. Section 267(c)(4).

• Stock constructively owned by a person by reason of section 267(c)(1), for purposes of applying section 267(c)(1)- (3), is treated as actually owned by such person. Section 267(c)(5).

• However, stock constructively owned by an individual pursuant to (c)(2) or (3) is not treated as owned by him for the purpose of again applying either of such sections in order to make another the stock’s constructive owner.

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Section 267(e)(3): Partnership Attribution

• Section 267(e)(3) provides that for purposes of determining ownership of a capital interest or profits interest of a partnership, the principles of section 267(c) shall apply, except that: (1) section 267(c)(3) (partner attribution) shall not apply; and (2) 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.

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Section 267(f): Controlled Group Deferral Rule • Section 267(a)(1)/(d) loss suspension/transfer does not apply to any loss

from the sale or exchange of property which is “between members of the same controlled group” (as defined in 267(f)(1))

• Instead, loss 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”

• Complex regulations apply “consolidated return principles” relating to timing (e.g., matching and acceleration rules) with adjustments

• Exceptions for DISCs, inventory transactions with foreign counterparty, foreign currency transactions

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Other Related Party Loss Disallowance Rules • Section 163(j): Disallows portion of interest expenses between certain related

persons where obligor has meets a specified debt-equity ratio • Section 707(b)(1): Disallows deduction for losses from sales or exchanges of property,

directly or indirectly, between 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 two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests – Section 267(d) suspended loss treatment applicable to transferee as if the loss

were disallowed under section 267(a)(1)

Slide Intentionally Left Blank

Section 1239: Re-characterization Rules

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Scope • Applies to recognized gains only, not losses. • Applies to redemptions of stock from related shareholders in exchange for

depreciable property. • Applies to transactions between any two related parties, without regard to

which entity is the transferor. • Applies to property that in the hands of the transferee is subject to

depreciation. • Applies also to amortizable section 197 intangibles. Treas. Reg. § 1.197-

2(g)(8). • Applies even though the transferee fails to claim depreciation deductions. • Applies to patent applications.

Exceptions • Excludes nontaxable exchanges (e.g., section

1031 exchanges) • Excludes nontaxable incorporations (e.g., section

351 transactions), but applies to recognized gain on “boot” in section 351 transaction

• Does not apply to property subject to the allowance for depletion.

• Excludes non-depreciable property (e.g., land), but can apply to related party landlord’s gain on lease cancellation.

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Section 1239: A Re-characterization Rule • Section 1239(a):

– “In the case of a sale or exchange of property, directly or indirectly, between related persons, any gain recognized to the transferor shall be treated as ordinary income if such property is, in the hands of the transferee, of a character which is subject to the allowance for depreciation provided in section 167.”

• Primarily relevant to individual transferors • Corporate tax observation

– When, as now, there are no preferential corporate-level capital gains rates, recharacterization generally only relevant to corporations with respect to use of capital loss carryforwards

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Section 1239(b): “Related Persons” • Relevant for section 1239 and section 453 (installment sale treatment) • For purposes of section 1239(a) , the term “related persons” means—

– a person and all entities which are controlled entities with respect to such person (“Controlled Entity Relatedness”)

– a taxpayer and any trust in which such taxpayer (or his spouse) is a beneficiary, unless such beneficiary’s interest in the trust is a remote contingent interest (“Trust-Beneficiary Relatedness”)

– 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 (“Executor-Beneficiary Relatedness”)

– an employer (and any person related to the employer) and a welfare benefit fund which is controlled directly or indirectly by such employer (or related person) (“Employer-Fund Relatedness”)

• Note: Treas. Reg. § 1.1239-1 largely dates to 1976 and has not been updated for amendments to section 1239 made in 1980, 1982, 1984, 1986 and 1997

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Section 1239(b)(1): Constructive Ownership • “Ownership shall be determined in accordance with rules similar to the rules

under Section 267(c) (other than paragraph (3) thereof )” – Section 267(c)(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 (“Upward Attribution”)

• Note: No downward attribution, e.g., shareholder to corporation (excludes 267(c)(3)) – Section 267(c)(2),(4): An individual shall be considered as owning the stock

owned, directly or indirectly, by or for his family (i.e., only brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants) (“Family Attribution”)

• Note: Inclusion of brothers/sisters/grandparents makes 267(c)(2) broader than 318(a) – Section 267(b)(5): Stock constructively owned by a person by reason of the

application of paragraph (c)(1) shall, for the purpose of applying paragraph (c)(1) or (c)(2), be treated as actually owned by such person, but stock constructively owned by an individual by reason of the application of paragraph (c)(2) shall not be treated as owned by him for the purpose of again applying (c)(1) or (c)(2) in order to make another the constructive owner of such stock (“Reattribution”)

• No in-law attribution. See PLR 200133030.

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Section 1239(b)(1): Controlled Entities • Section 1239(b)(1): A person and all entities which are controlled entities with respect to

such person (“Controlled Entity Relatedness”) – Person “shall be construed to mean and include an individual, a trust, estate,

partnership, association, company or corporation.” Section 7701(a). – “Controlled Entity,” with respect to any person, means

• a corporation more than 50 percent of the value of the outstanding stock of which is owned (directly or indirectly) by or for such person

– Note: This is a value test, not a vote test

» Measuring “value”: Not just share count. Control premium? Options?

» When are shares counted? Subscription? Courts look to local law

– “Directly or indirectly” • a partnership more than 50 percent of the capital interest or profits interest in which is

owned (directly or indirectly) by or for such person – Note: Capital or profits; how to determine the size of a “capital interest” or a “profits

interest” with respect to a partnership? • any entity which is a related person to such person under paragraph (3) , (10) , (11) or (12) of

section 267(b)

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Section 1239(b)(1): Controlled Entities (cont.) • Section 1239(c)(1)(C): A person and any entity which is a related person to such

person under paragraph (3) , (10) , (11) or (12) of section 267(b) – Two corporations which are members of the same controlled group (i.e., a 267(f)

controlled group) – 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

– 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;

– 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

• When is relatedness determined? – If transferor is an entity, control tested immediately before OR after – If transferor is not an entity, control tested only immediately after

• Permits sell-downs by non-entity transferors if simultaneous with related party transaction

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Section 1239(b)(2): Trust-Beneficiary

• Section 1239(b)(2): A taxpayer and any trust in which such taxpayer (or his spouse) is a beneficiary, unless such beneficiary’s interest in the trust is a remote contingent interest (“Trust-Beneficiary Relatedness”) – A contingent interest of a beneficiary in a trust shall be considered remote if,

under the maximum exercise of discretion by the trustee in favor of such beneficiary, the value of such interest, computed actuarially, is 5 percent or less of the value of the trust property. See Section 318(a)(3)(B)(i).

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Section 1239(b)(3): Executor-Beneficiary

• Section 1239(b)(3): 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 – Applies on the deemed “sale or exchange” on a distribution of property

in satisfaction of a pecuniary bequest

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Section 1239(d): Employer-Fund • Section 1239(d) relatedness is between:

– an employer (and any person related to the employer), and – a welfare benefit fund (within the meaning of section 419(e)) which is

controlled directly or indirectly by such employer or related person (“Employer-Fund”)

• “Welfare benefit fund” is any fund which is a part of a plan of an employer, and through which the employer provides “welfare benefits” to employees or their beneficiaries – The IRS has privately ruled that welfare benefits include major medical,

hospitalization, death benefits, accidental death and dismemberment, prescription drugs, dental benefits, short and long term disability benefits, holiday and sick pay benefits, vacation pay benefits and post-retirement medical and death benefits

Conduit Transfers • Gains from sales between related

corporations may be treated as ordinary income taxable to a controlling shareholder rather than the transferor corporation if determined that the transferor corporation is used by a controlling shareholder as a mere conduit to make a sale to another controlled corporation, or the entity of the corporate transferor is otherwise properly disregarded for tax purposes

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Section 1239 Examples • Modifications of Treas. Reg. § 1.1239-1(c)(5) Exs. 1-2: • A, an individual, owns 51 percent of the stock (by value) of Corporation X.

Any gain A recognizes from the sale of depreciable property to Corporation X is treated under section 1239 as ordinary income.

• P and his daughter, D, each own 26 percent in value of the Y Corporation stock. Y Corporation owns 100 percent in value of the stock of Z Corporation. P sells depreciable property at a gain to Z Corporation. Under the constructive ownership rules of section 267(c)(1), as applied to section 1239, P and D are each considered to own their proportionate share of the stock in Z Corporation owned by Y Corporation. Under the constructive ownership rules of section 267(c)(2), as applied to section 1239, P and D are each considered to own the stock in Y Corporation owned by the other and, under section 267(c)(5), are considered to actually own the stock for purposes of applying 267(c)(1) . As a result, both P and D each constructively own 52 percent or more in value of the stock of both Y and Z Corporations. The sale between P and Z is governed by section 1239 and produces ordinary income to P.

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Other Related Party Recharacterization Rules • Section 1235 • Section 108(e)(4) • Section 707(b)(2)

Slide Intentionally Left Blank

Like Kind Exchanges

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Section 1031: Overview • The legislative history of section 1031 provides that "if [an exchanger's]

money is still tied up in the same kind of property as that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the exchange, nor is he charged with a tax upon his theoretical profit. The calculation of the profit or loss is deferred until it is realized in cash, marketable securities, or other property not of the same kind having a FMV."

• Thus, no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

• “Like-kind property” is defined as property held for productive use in a trade or business or for investment that is exchanged solely for similar property.

• The basis of the property acquired is the same as the basis of the property exchanged, decreased by any boot (property other than like-kind) received and increased (or decreased) by the gain (or loss) recognized by the taxpayer.

Section 1031(f): Like Kind Exchanges between Related Parties

• Section 1031(f) was enacted in 1989 to limit the application of section 1031 in to related party exchanges.

• Congress was concerned that related parties were exchanging properties to shift basis under the section 1031(d) substituted basis rules.

• The Finance Committee report on section 1031(f) states “Because a like-kind exchange results in the substitution of the basis of the exchanged property for the property received, related parties have engaged in like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property in order to reduce or avoid the recognition of gain on the subsequent sale. Basis shifting also can be used to accelerate a loss on retained property. The committee believes 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.”

• Thus, Congress set forth a 2-year period between the exchange and a subsequent sale by the exchanger.

• Section 1031(f) was enacted using the same principles as section 453(e).

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Like Kind Exchanges between Related Parties

• If, before the date 2 years after the date of the last transfer which was part of such exchange, the related person disposes of such property, or the taxpayer disposes of the like-kind property received in the exchange, non-recognition treatment is foregone.

• Gain must then be recognized as of date of the last transfer in the initial 1031 exchange.

• “Related person” is defined by reference to sections 267(b) and 707(b)

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Section 1031(g): Substantial Diminution of Risk of Loss During the 2- Year Period

• If the holder's risk of loss on the property is substantially diminished during any period, that period is not counted in determining whether the property was disposed of within 2 years.

• The property holder's risk of loss is substantially diminished by:

• The holding of a put on the property; • The holding by another person of a right to acquire the

property; or • A short sale or any other transaction.

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Example: Option • T exchanges property with R, a related party. • One year later, A, a third party buys a one-year option

from R to buy the property from R. • The option is not exercised and expires a year later. • R sells the property 7 months later to B, an unrelated

buyer. • Result: Even though the sale by R is 31 months after

the original exchange, T’s gain from the original exchange is triggered, because the two-year holding period was suspended during the time the option was outstanding, so the sale is deemed to occur only 19 months after the exchange.

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Section 1031(f)(4): Anti Avoidance Rule

• Section 1031(f) does not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of section 1031(f).

• The House report explaining the rule provides an example that demonstrates an application of section 1031(f)(4) to a situation in which the exchanger and related party do not directly exchange property.

• In that example, an exchanger and a related party plan a transaction to circumvent section 1031(f)(1) under which the related party transfers property to an unrelated party.

• Under the prearranged plan and within two years after buying the property from the related party, the unrelated party exchanges that property with the exchanger.

• Just as would have been the situation if the exchanger had directly exchanged its property with the related party who then transferred it to the unrelated party, at the end of the transaction, the related party holds the consideration from the unrelated party, the unrelated party owns the exchanger's property, and the exchanger owns the related party's property acquired in an exchange.

• Consequently, the House report concludes that under section 1031(f)(4), the exchanger is not allowed section 1031(a)(1) nonrecognition.

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Revenue Ruling 2002-83

• In Revenue Ruling 2002-83, related parties exchanged property using a qualified intermediary (QI) and, as part of that transaction, one of the related parties receives cash or other non–like-kind property in the exchange.

• The IRS applied the anti-abuse provision of section 1031(f)(4), holding that the QI was used to circumvent the purpose of the related-party rules and, therefore, the non-recognition provisions of section 1031 do not apply.

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FSA 200137003: the Interaction between the 2-Year Rule and Anti Avoidance Rule

• The IRS confirmed that when related parties exchange properties, non-recognition treatment of the gain under section 1031(f) is permitted as long as the subsequent disposition of the replacement property occurs after two years of the initial exchange.

• The IRS emphasized that “the two-year rule in section 1031(f)(1)(C) is a safe harbor that precludes application of section 1031(f)(1) to any transaction falling outside that period.”

• The IRS observed that the purpose of the anti-abuse provision is to “stop taxpayers from violating the two-year rule, and not to preclude taxpayers from planning to dispose of property after the two-year period.”

• Thus, there is no abuse where parties enter into a related-party exchange with the intent of selling the property after two years without triggering recognition of the original gain.

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Other Exceptions: Section 1031(f)(2) • Dispositions after the earlier of the death of the

taxpayer or the death of the related person • A compulsory or involuntary conversion (within

the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion.

• An exchange with respect to which 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.

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Lack of Tax-Motivated Purpose

• The legislative history of section 1031(f)(2) provides that:” It is intended that the non-tax avoidance exception generally will apply to: (i) a transaction involving an exchange of undivided interests in different properties that results in each taxpayer holding either the entire interest in a single property or a large[r] undivided interest in any of such properties; (ii) dispositions of property in nonrecognition transactions; and (iii) transactions that do not involve the shifting of basis between properties.

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Lack of Tax-Motivated Purpose (Cont.)

• The following facts may imply that there was no tax avoidance motivation:

• The subsequent disposition was innocent and had no tax avoidance purpose (PLR 199926045);

• The lack of a prearranged plan to subsequently dispose of the property; or

• an exchange that provides no tax advantage to either party.

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Installment Sales and Related Parties

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Section 453: Overview • Sec 453(a) provides that, except as otherwise provided in sec 453 and 453A,

income from an “installment sale” is taken into account under the “installment method.”

• Sec. 453 is the default rule, available without election, but a taxpayer may elect out of section 453 on the tax return for the year of sale.

• Sec 453(b)(1) provides that "installment sale" means a disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs.

• Sec 453(c) provides that the "installment method" means a method under which the income recognized for any taxable year from a disposition is that proportion of the payment received in that year which the gross profit (realized or to be realized when the payment is completed) bears to the total contract price.

• The installment method is not available for sales of inventory, for property held for sale to customers, and for stock or other securities regularly traded on an established market.

• Sec 453A imposes an interest charge in respect of taxpayers that hold notes that are subject to the installment method of accounting with an aggregate principal amount in excess of $5M (which effectively eliminates the benefit of the deferral by imposing an interest charge on the deferred tax liability)

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Section 453(e) • Sec 453(e) generally accelerates the gain reportable by

the original seller of property under the installment method if a related-party transferee disposes of the property within 2 years after the original sale.

• Thus, Sec 453(e) prevents a taxpayer from using the installment sale rules to defer gain recognition when a related party resells the property within two years after the original sale.

• If section 453(e) applied to the related-party sale, the taxpayer would recognize gain on receipt of installment payments.

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Section 453(e)(1) • If any person disposes of property to a related

person (the “first disposition”), and before the person making the first disposition receives all payments with respect to such disposition, the related person disposes of the property (the “second disposition”), then, the amount realized with respect to the second disposition is treated as received at the time of the second disposition by the person making the first disposition.

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Suspension of Holding Period

• Section 453(e)(2)(B) provides that the running of the 2-year period set forth in section 453(e)(2)(A) will be suspended with respect to any property for any period during which the related person's risk of loss with respect to the property is substantially diminished by (i) the holding of a put with respect to such property (or similar property), (ii) the holding by another person of a right to acquire the property, or (iii) a short sale or any other transaction.

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“Related Parties”

• Sec 453(f)(1), defines the term related person as a person whose stock would be attributed under sec 318(a) (other than paragraph (4) thereof) to the person first disposing of the property, or a person who bears a relationship described in sec 267(b) to the person first disposing of the property.

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Single Economic Unit • The effect of section 453(e) is to treat the taxpayer and related party as if

they were a single economic unit. • If the amount of the payments received with respect to the second

disposition is in excess of the amount of the payments taken into account with respect to the first disposition, the excess is treated as if it were a payment with respect to the first disposition.

• The gain inherent in such excess is required to be recognized as the economic unit has "cashed out" that portion of its investment in the property which was sold.

• Continued availability of the installment method for the related party sale would facilitate tax avoidance, i.e., the taxpayer would defer the tax on the related party installment sale while a second disposition for cash would result in no gain.

• Absent section 453(e), the taxpayer could structure the installment sale so no principal payments would be due and no income recognized until some distant future date.

• The time value of the investment return on the tax savings could fund the eventual tax payment.

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No Tax Avoidance Purpose • Under sec. 453(e)(7), gain to the taxpayer is not

accelerated under sec. 453(e)(1) by reason of the related party's resale within two years if the Treasury secretary is satisfied that neither the sale to the related party nor the related party's resale within the two-year period had as one of its principal purposes the avoidance of federal income tax.

• Thus, related-party re-sales outside the two-year period generally do not trigger acceleration to the taxpayer, whereas re-sales within the two-year period, if not rebutted by the non-tax-avoidance exception, generally do.

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Section 453(g) • Sec 453(g)(1)(A) provides that in the case of

an installment sale of depreciable property between related persons section 453(a) does not apply.

• Sec 453(g)(3) provides that for purposes of sec 453(g), the term related persons has the meaning given to such term by sec 1239(b), except that such term shall include 2 or more partnerships having a relationship to each other described in sec 707(b)(1)(B).

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