Related Party Transactions
It is often common for individuals to make transactions with family members or businesses owned by family members. Did you know those transactions could have a negative tax consequence for you?
Related party transactions in most cases will re-characterize what would normally be a long-term capital gain or loss to an ordinary gain or loss. The property sold between parties must be depreciable to fall under the related party rules. If the sale includes both depreciable and non-depreciable property, the gain will be allocated between the properties and only the depreciable property will be re-categorized from capital gain to ordinary gain. Capital gain tax rates for the 2019 filing season could be as low as 0% or as high as 20% depending on your taxable income level. For example, if your taxable income for 2019 was $78,000 and you file a married filing joint tax return, your tax bracket would be 12% and your long-term capital gains tax rate would be 0%. If you sold $50,000 worth of raised cows to your brother, resulting in a $50,000 long-term capital gain it would be taxed at 0% according to your taxable income, but since it is a related party transaction, that $50,000 long-term gain will instead be taxed at 12%.
What family members fall under the related party transaction rules? Family members included in the related party transaction rules include siblings (including half siblings), spouses, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.). A sale between a taxpayer and their nephew would NOT fall under the related party transaction rules.
In addition to sales between individual taxpayers, sales between entities could also fall under the related party transaction rules and result in unfavorable tax consequences. Related party rules can apply when there is a sale between a taxpayer and a controlled entity or a sale between multiple controlled entities. Controlled entities include a corporation or partnership in which the taxpayer owns directly or indirectly more than 50% of the stock or capital or profits interest. Controlled entities would also include two corporations or partnerships in which the same taxpayers own more than 50% of the outstanding stock or capital and profits interest.
For example, let’s say Taxpayer A is in a partnership named XYZ Partnership with Taxpayer B and they are brothers. They both share profits and capital at 50% each. XYZ Partnership sells $100,000 of raised cows to ABC Corporation for breeding purposes. ABC Corporation is owned by the two brothers and Taxpayer C, an unrelated taxpayer. Each taxpayer owns one third of the outstanding stock in ABC Corporation. Since Taxpayer A and B are brothers and both own one third of ABC Corporation, due to related party rules, they are considered to directly or indirectly own two thirds of ABC Corporation. The sale of $100,000 of raised cows from XYZ Partnership to ABC Corporation for breeding purposes would be considered a related party transaction because 50% or more of XYZ Partnership and ABC Corporation is owned by related parties. The $100,000 will be taxed as an ordinary gain to XYZ Partnership and flow through on the partners K1s to be taxed at their regular tax rate rather than the lower capital gains rate.
Related party transactions can be quite technical and complex. If you think you might fall within the related party rules or would like to know more about them, contact the KTLLP Tax Team for more information.