Related Party Transaction Rules: IRC Sections 267 and 707(b) for the CPA Exam

Related Party Transaction Rules for CPA Candidates

The Internal Revenue Code imposes special rules on transactions between related parties to prevent tax manipulation. Two primary Code sections govern these transactions: Section 267 (which addresses losses and certain expenses between related parties) and Section 707(b) (which applies specifically to partnerships and their partners). These rules are frequently tested on the CPA REG exam and require understanding of both the substantive rules and the constructive ownership provisions.

Section 267: Loss Disallowance and Matching Rules

Loss Disallowance Rule

Under Section 267(a)(1), no deduction is allowed for losses from sales or exchanges of property between related parties. Unlike the wash sale rule, this loss is not merely deferred with a basis adjustment to the seller. Instead, the buyer receives a unique benefit: if the buyer later sells the property at a gain, the previously disallowed loss can offset that gain. However, this offset only reduces or eliminates gain; it cannot create or increase a loss for the buyer.

For example, a father sells stock to his daughter for $6,000 when his basis is $10,000. The $4,000 loss is disallowed. The daughter's basis is her cost of $6,000. If the daughter later sells the stock for $12,000, her realized gain is $6,000, but the $4,000 previously disallowed loss offsets it, resulting in a recognized gain of only $2,000. If the daughter sells for $7,000, her gain is $1,000, offset by $1,000 of the disallowed loss, resulting in zero recognized gain (with $3,000 of the disallowed loss permanently lost). If the daughter sells for $5,000, she has a $1,000 realized loss. The father's disallowed loss cannot increase her loss, so she recognizes only her own $1,000 loss.

Matching Rule for Expenses

Section 267(a)(2) addresses the timing of deductions for expenses owed by an accrual-basis taxpayer to a related cash-basis taxpayer. The accrual-basis payor cannot deduct the expense until the cash-basis payee includes the amount in income. This prevents an entity from accruing a deduction in one year while the related payee defers recognition to a later year.

This rule commonly applies to compensation owed by a closely held corporation (accrual basis) to its owner-employees (cash basis). If the corporation accrues a bonus on December 31 but does not pay it until February of the following year, the deduction is deferred to the year of payment.

Who Are Related Parties Under Section 267?

Section 267(b) defines related parties to include: members of a family (siblings, spouse, ancestors, and lineal descendants but not aunts, uncles, or cousins); an individual and a corporation in which the individual owns more than 50% of the stock (by value); two corporations that are members of the same controlled group; a grantor and a fiduciary of a trust; a fiduciary and a beneficiary of the same trust; a corporation and a partnership if the same persons own more than 50% of each; and various other entity combinations.

Constructive Ownership Under Section 267

Section 267(c) applies constructive ownership rules to determine related party status. Stock owned by family members, partners, and entities is attributed to the taxpayer. These attribution rules can expand the definition of "related parties" significantly. Notably, under Section 267, the family attribution rules do not include constructive ownership from siblings for certain purposes, and re-attribution (attribution through chains) is limited.

Section 707(b): Partnership-Related Transactions

Section 707(b) disallows losses on sales between a partnership and a partner (or between two partnerships) when the same persons own more than 50% of the capital or profits interests. It also recharacterizes gain as ordinary income on the sale of property between these related parties if the property is not a capital asset in the hands of the buyer. Like Section 267, the disallowed loss can offset subsequent gains realized by the buyer.

CPA Exam Strategies

• Identify the relationship first: family, individual-entity, or entity-entity.
• Apply the correct constructive ownership rules for the relevant Code section.
• For losses: the loss is disallowed to the seller; the buyer can offset future gains but cannot create a loss.
• For accrual-to-cash matching: deduction is deferred to the year of payment/inclusion.
• Watch for the "more than 50%" threshold, which differs from the "50% or more" threshold used in other provisions.