Disallowed Losses, Constructive Ownership & Deferred Gains

19.1 Disallowed Losses, Constructive Ownership & Deferred Gains

Disallowed losses, constructive ownership, and deferred gains are core components of understanding how the Internal Revenue Code (IRC) approaches tax reporting for transactions between related parties. Under specific IRC provisions—most notably §267 and §318—gains or losses recognized in dealings within family and affiliate structures can be disallowed or deferred. For CPA candidates, mastering these rules is vital, as you will often encounter them not only on the exam but also in real-world tax practice. This section clarifies how direct or indirect family relationships can trigger disallowance of immediate losses (and sometimes gains), and outlines where deferred gains can arise. We also provide a practical “cheat sheet” on ownership attribution to help you navigate the complexities of constructive ownership.

Overview of Related-Party Transactions

Related-party transactions involve individuals or entities with close ties—whether familial or economic. When such transactions occur, the IRS imposes restrictions on recognizing losses (or adjustments to gains) to close loopholes and prevent artificial loss harvesting. For instance, a parent might attempt to sell depreciated property to a child at a loss to claim a tax deduction while keeping the property within the family. Section 267 ensures that such losses are disallowed for tax purposes.

Key Aspects to Remember

• Disallowed Losses: Often occur in transactions between related parties.
• Constructive Ownership: A legal fiction that attributes individual ownership to other family members or entities to curb possible abuse.
• Deferred Gains: Certain gains may not be recognized immediately but carried over and recognized in the future under specific circumstances.

Major Code Sections Impacting Disallowed Losses & Constructive Ownership

1. IRC §267 – Identifies related parties and disallows losses on sales or exchanges between them. It also can affect the timing and recognition of gains.
2. IRC §318 – Defines constructive ownership rules, especially relevant for stock ownership in corporations, S corporations, or partnerships.
3. Other Sections – Various supplementary provisions—such as §707 in partnership contexts—can also influence whether a transaction is considered to be occurring at arm’s length.

CPA candidates and tax practitioners must be fluent in these rules to address exam questions accurately and advise clients on structuring transactions.

Defining “Related Parties” Under Section 267

Section 267 comprehensively outlines who is considered a related party. Family relationships are the most common scenario, encompassing:

• Spouses.
• Siblings.
• Ancestors (parents, grandparents).
• Lineal descendants (children, grandchildren).

Additionally, related parties include certain corporate, partnership, estate, and trust relationships if a controlling interest is present. The goal is to ensure that a taxpayer cannot generate artificial losses by moving assets within their close circle.

Practical Example: Parent-to-Child Sale

A parent sells stock to a child, generating a $5,000 loss. Since this transaction is between related parties, the parent’s loss is disallowed under §267. Further, the disallowed loss is not merely “gone” in all circumstances—some or all of it might affect the child’s basis if that child later sells the asset. The complicated interplay of basis adjustments is important to watch out for on the exam and in professional practice.

Constructive Ownership Rules (IRC §318)

Constructive ownership refers to ownership that is deemed to exist for tax purposes, even if not directly titled in the taxpayer’s name. This concept prevents taxpayers from bypassing related-party rules by transferring ownership to a relative or another controlled entity. Section 318 ownership rules often apply to:

• Stock owned directly or indirectly by a spouse, child, or parent.
• Stock owned by an entity such as a corporation, partnership, or trust, if the individual has a sufficient ownership interest in that entity.
• Certain options to purchase stock that may be treated as if the individual already owns the stock.

Constructive ownership can be particularly tricky. For example, if you own 50% of a corporation, and that corporation owns 50% of a second subsidiary, you may be attributed ownership of the shares owned by that subsidiary to evaluate whether a transaction is occurring between related parties.

Attribution Rules Cheat Sheet

Use the following cheat sheet for a quick reference on how constructive ownership might apply to your client or exam question:

Illustrative Ownership Attribution Diagram

Below is a sample Mermaid diagram showing how constructive ownership might flow among individuals and entities in a hypothetical scenario.

    flowchart LR
	    A[John] -->|50% Ownership| B(Corp X)
	    B -->|60% Ownership| C(Subsidiary Y)
	    A -->|Parent of| D(Sarah)
	    D -->|25% Ownership| E(LLC Z)
	
	    style A fill:#f9f,stroke:#333,stroke-width:1px
	    style B fill:#bbf,stroke:#333,stroke-width:1px
	    style C fill:#bbf,stroke:#333,stroke-width:1px
	    style D fill:#f9f,stroke:#333,stroke-width:1px
	    style E fill:#bbf,stroke:#333,stroke-width:1px

In this example:
• John directly owns 50% of Corp X, which in turn owns 60% of Subsidiary Y. Constructive ownership rules may attribute John ownership of some or all of Subsidiary Y’s holdings.
• Sarah (John’s child) owns a 25% stake in LLC Z. John may be considered indirectly tied to LLC Z under certain rules, though direct parent-child attribution generally applies to stock ownership rather than membership interests—but analogous principles can apply in certain pass-through contexts.

Disallowed Losses in More Detail

When a taxpayer sells property to a related party at a loss, §267 generally disallows that loss. This means the loss cannot be recognized on the taxpayer’s return. However, there may be implications for the basis in the hands of the transferee.

Key Mechanics

1. Loss Disallowance: The seller cannot claim the loss on their tax return.
2. Transferee’s Basis: If the asset appreciates and the buyer sells it at a gain later, part or all of the previously disallowed loss may reduce the gain recognized at that time, depending on certain conditions.

Example: Disallowed Loss & Future Basis Adjustment

• Jane sells stock to her adult son, Mike, for $10,000, creating a $3,000 realized loss for Jane. Because this is a §267 transaction, the $3,000 loss is disallowed.
• If Mike sells the stock in a future year for $15,000, any potential gain might be adjusted downward by the $3,000 disallowed loss, so that Mike might only recognize $2,000 of gain ($15,000 – $10,000 – $3,000). However, this depends on satisfying the rules regarding the transaction’s timing and the basis carryover.

Constructive Ownership & Gain Shifting

Sometimes, instead of disallowed losses, the transaction might produce artificially low or high gains if the parties were unrelated. Constructive ownership may force a taxpayer to realize gain earlier than expected or at a higher level if the IRS deems that the transaction did not occur at arm’s length.

Joint Ownership Example

• Suppose a parent and child jointly own a piece of rental property. If the arrangement is structured in a manner designed to shift income or deductions artificially, the IRS can use constructive ownership rules to reallocate income or deny certain deductions.

Deferred Gains: When Recognition Is Delayed

While disallowed losses are the spotlight of §267, there are also instances under other Code sections where gains might be deferred when related parties exchange property. For example:

• Like-Kind Exchanges (§1031): Gains can be deferred if the property exchanged is real property held for business or investment. However, related-party transactions under a §1031 exchange have special rules that require the exchanged property to be held for a minimum of two years to avoid gain recognition.
• Partnership Distributions: Under §707(b), if a partnership distributes property to a related partner (including a controlling partner or related entity), the transaction may be recharacterized, potentially triggering or deferring gain recognition.

The CPA exam might test your ability to identify when a transaction involving related parties defers or disallows gains, and how that deferral might end if certain holding periods are not satisfied.

Tax Planning Considerations

1. Avoid Synthetically Shifting Losses: Since disallowed losses under §267 cannot be deducted, families and closely held businesses should seek strategies to avoid inadvertently creating transactions that risk disallowance.
2. Basis Planning: Understanding how disallowed losses might later reduce a transferee’s potential gain allows for strategic asset management over time.
3. Entity Choice: Work with partnerships, S corporations, or C corporations in ways that minimize the adverse effects of constructive ownership rules and disallowed losses.
4. Exit Strategies: If a sale is planned within a family, consider waiting until an unrelated third-party transaction is possible to realize legitimate losses while preserving family wealth.

Real-World Scenario: Family-Owned Business

Imagine a multi-generational family business (e.g., a local manufacturing shop). The parents hold 70% ownership, with the children owning 30%. The family decides to transfer a piece of equipment between the parents’ partnership and the children’s wholly owned corporation, claiming a loss in the process. Upon closer examination:

1. Attribution: The parents are constructive owners of the children’s corporation because of their controlling interest in the partnership and the close familial relationship.
2. Loss Disallowance: Because both sets of owners are considered “related parties,” any resulting loss on the sale is disallowed.
3. Future Adjustments: If the children’s corporation sells the equipment at a future gain, some or all of the disallowed loss might be used to reduce that gain, if it meets all relevant statutory requirements.

Potential Pitfalls & Best Practices

Below are some key pitfalls to avoid and best practices to adopt:

Pitfalls

• Unintentionally Triggering §267 Disallowance: Selling property to a related party below market value without realizing that the transaction might disallow an otherwise deductible loss.
• Overlooking Constructive Ownership: Failing to consider how family members or controlled entities might automatically attribute ownership, resulting in negative tax consequences.
• Misclassifying Gains: Assuming a partial or total gain is tax-free or deferred when in reality the related-party rules require immediate recognition.

Best Practices

• Document Transactions Thoroughly: Even among family members, maintain evidence that the sale price is fair market value.
• Plan Holistically: If you want to preserve losses, consider timing strategies or structuring the transaction with an unrelated intermediary (provided it meets all legal parameters and does not constitute a stepped transaction).
• Keep Up with Legislative Changes: Rates, thresholds, or definitions of related parties can shift over time, so stay informed of new statutory updates or rulings.

Practical Ownership Attribution “Cheat Sheet”

To help you remember key constructive ownership scenarios, reference the chart below:

1. Family Attribution
   • From an individual to spouse, children, grandchildren, and parents.
   • Siblings do not directly attribute ownership to each other unless an intermediate party triggers it (like a parent or an entity).
2. Entity-to-Owner Attribution
   • Ownership from an entity (corporation, partnership, LLC, trust) to an owner if the owner’s stake ≥ 50%.
   • Careful with multiple tiers: “Grandchild” ownership of multiple tiers of entities can attribute back to the original individual.
3. Option Attribution
   • If an individual holds an option to acquire stock, the IRS may treat that person as already owning the stock for certain tests (e.g., ownership thresholds in redemption or distribution situations).

Diagrams & Tables to Reinforce Learning

For those who learn visually, the following table reflects different transactions and their potential tax treatment outcomes:

Exam-Taking Strategies

1. Focus on Definitions: Precisely identify related parties as defined under §267 and constructive ownership under §318.
2. Apply the Disallowance: If a transaction is indeed between related parties, check if a loss is disallowed or a gain is deferred.
3. Carryover & Impact: Pay close attention to how basis is adjusted for the transferee if a future sale occurs.
4. Look for Exceptions: Some Code sections or specific exceptions (like certain stock redemptions or multi-layered transactions) might override or modify the general rule.

References for Further Exploration

• IRC §267, §318, and related Treasury Regulations — for detailed definitions and attributions.
• IRS Publication 544 (Sales and Other Dispositions of Assets) — provides plain-language guidance.
• AICPA Tax Section Library — offers case studies and professional guidance on related-party transactions.
• Internal Revenue Manual (IRM) — advanced-level guidance, especially for exam controversies.

Conclusion

Disallowed losses, constructive ownership, and deferred gains can appear daunting at first glance, but they become much more approachable once you break them down into their core elements. Be sure to understand who qualifies as a “related party,” how constructive ownership is determined to prevent circumvention, and when losses or gains must be disallowed or deferred. By mastering these principles, you not only ease your path through the Uniform CPA Examination’s Tax Compliance and Planning section but also build a robust foundation for your tax advisory career.

In the next sections of this Part V on Property Transactions, you will see how these related-party concepts integrate with more complex transactions such as installment sales, §1031 exchanges with family members, and multilayered LLCs or corporate structures.

Remember: vigilance is key. The IRS designed these rules to thwart any attempt to generate artificial deductions or manipulations. A well-prepared CPA can navigate these codes to serve clients effectively and ethically.

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