1. Sec. 267 was enacted to disallow certain losses and deductions on transactions between related taxpayers. Without such a provision, related parties could create fictitious tax losses that lack economic substance since the "family unit" (e.g., the related parties) continue to enjoy the property subject to the loss sale.
2. Sec. 267(a) disallows two specific types of deductions: (1) a loss on the sale or exchange of property between related parties and (2) a deduction for a payment to a related party who has not included the item in income. The latter restriction is designed to prevent related taxpayers from taking advantage of an unwarranted deferral of income because of different methods of accounting, and is discussed in Part II.
3. A “related party” is defined in Code Sec. 267 as including family members, a taxpayer and a corporation controlled directly or indirectly (through attribution from other family member stock holdings) by the taxpayer (more than 50% of the value of the stock), and a partner and a controlled (directly or indirectly) partnership. Sec. 267 also specifies other related parties, including a trust and its grantor, a trust and its beneficiary, and a personal services company and any shareholder-employee.
4. Family members are defined as related parties include brothers and sisters, spouse, ancestors, and lineal descendants. In-laws and step relationships are not related parties, and losses on sale or exchanges with these parties may be deducted unless the in-law or step relationship is merely acting as a nominee for a related party. Half-brothers and half-sisters are related parties. These same relationships are used in the stock attribution rules described next.
5. In determining if a corporation and a shareholder are related parties, a series of constructive ownership rules specified in Sec. 267(c) are applied. In effect, these rules equate control with ownership, in that stock held by certain related parties is treated as though it is held by the taxpayer. The same is true of two corporations controlled, directly or indirectly, by the same person. Any transaction between a personal services corporation and an employee owner are automatically classified as related parties (regardless of the ownership percentage of the employee owner).
6. The attribution rules can be summarized as follows (these are the same rules discussed in Part 2 that are applicable to partnerships):
Rule 1 - An interest owned directly or indirectly by a corporation, partnership, estate or trust is treated as owned proportionately by its shareholders, partners, or beneficiaries.
Example - Sue Acca owns 40% of Bee Company, which in turn owns 30% of ABC Company. Sue is treated as owning 12% of ABC (40% x 30%) through her holdings of Bee Company stock.
Rule 2 - An individual is treated as owning any corporate interests held by his “family,” where family includes brothers, sisters, half-brothers, half-sisters, spouses, ancestors (e.g., parents, grandparents, etc.), and lineal descendants (e.g., children, grandchildren, etc.).
Example – Judy Graham owns a 40% interest in JJJ Corporation, her husband John owns a 10% interest, her granddaughter owns a 5% interest, and her niece owns a 15% interest. For purposes of the attribution rules, Judy is treated as owning 55% of JJJ Corporation (40% + 10% + 5%); her niece is not a “related party” for these purposes.
Rule 3– A person having a constructive ownership interest under Rule 1 above (proportionate attribution) is treated as actually owning that interest for the purposes of applying either Rule 1 or Rule 2 in other situations (this is not considered double attribution). However, Rule 2 (family members) cannot be applied in this manner (this is considered to be double attribution).
Example – In the earlier example for Rule 1, Sue Acca was treated as constructively owning 12% of Bee Company (40% x 30%); thus, Sue’s husband James would have to include Sue’s 12% of Bee Company with any stock in Bee he actually owns when testing James for loss disallowance, since Sue’s constructive holdings are treated as actual holdings for these purposes.
Example – In the earlier example for Rule 2, Judy Graham was treated as constructively owning her husband’s 10% interest. However, that 10% interest could not also be attributed to Judy’s sister Jeanne, since this would involve double attribution with family members—from Judy’s husband John to Judy and then to Judy’s sister Jeanne.
Example - T owns 45% of the outstanding stock of C Corporation, and 30% of D Corporation. D owns 40% of C. T and C are related parties, because T is treated as constructively owning 12% of C through his holdings in D (30% x 40%). Thus, T owns directly or indirectly 57% of C (45% direct and 12% indirect).