Nondeductible Loss Sec 267

When it comes to filing taxes, not every financial loss is deductible under U.S. tax law. One important limitation that taxpayers must be aware of involves nondeductible losses under Section 267 of the Internal Revenue Code. This provision prevents taxpayers from claiming losses on certain transactions between related parties. While it might seem like a technical area of the tax code, understanding the rules under Section 267 is crucial for individuals and businesses to avoid unexpected tax liabilities and compliance issues. Whether you are selling property to a family member or transacting with a business entity you control, Section 267 can have a significant impact.

What Is Section 267?

Section 267 of the Internal Revenue Code deals with transactions between related parties. It was created to prevent tax avoidance by disallowing the deduction of losses on sales or exchanges of property between parties that have a close relationship. The primary intent of this rule is to ensure that tax benefits are not abused through artificial losses between controlled or connected taxpayers.

Main Purpose of Section 267

• Prevent manipulation of taxable income through artificial losses
• Close tax loopholes involving related party transactions
• Ensure that losses are only recognized when there is an actual economic loss

The code specifies a wide range of relationships and types of transactions that fall under its scope, from family members to corporations controlled by the same person or group.

Definition of Related Parties

Understanding who is considered a related party under Section 267 is essential. The term is broadly defined and includes both individuals and business entities. Transactions between these parties are subject to special scrutiny, and any loss realized in such a transaction may not be deductible.

Examples of Related Parties

• Family members such as parents, children, siblings, spouses, and grandparents
• A corporation and an individual who owns more than 50% of the value or voting power of the corporation
• Two corporations that are members of the same controlled group
• A partnership and a person who owns more than 50% of the capital or profits interest
• An S corporation and any of its shareholders who own more than 50%

The broad scope of the related party definition ensures that Section 267 applies in many situations, limiting tax deductions when financial control or close family ties exist.

Nondeductible Loss Rules

Section 267 disallows the deduction of any loss resulting from the sale or exchange of property between related parties. This includes capital losses and ordinary losses. The IRS treats these transactions as lacking true economic substance because the relationship between the parties makes the transaction less than arm’s length.

Key Provisions

• Losses from the sale of property between related parties are not deductible
• Only realized losses are affected unrealized losses are not impacted
• If the property is later sold to an unrelated third party, some or all of the disallowed loss may be used

This rule is particularly relevant in cases where a taxpayer might be tempted to sell property to a related party at a loss for the sole purpose of generating a tax deduction.

Illustrative Example

To better understand how Section 267 works, consider the following example:

John owns stock that he purchased for $10,000. He sells the stock to his brother for $6,000, realizing a $4,000 loss. Under normal circumstances, John might be able to deduct that loss. However, because the transaction is between related parties, Section 267 disallows the deduction.

Now, suppose John’s brother later sells the stock to an unrelated third party for $11,000. The brother’s gain would be $5,000 ($11,000 minus $6,000), but he may be able to reduce his gain by the previously disallowed loss of $4,000, resulting in a net taxable gain of $1,000. This is called a basis transfer benefit under Section 267(d).

Basis Adjustment and Loss Recapture

Although the original seller cannot deduct the loss in a related party transaction, the loss is not permanently lost. Under certain conditions, the related buyer may be able to recognize part or all of that disallowed loss upon the sale of the same property to an unrelated party. This is a key exception to the disallowance rule.

When Loss Can Be Recaptured

• The related buyer sells the asset to an unrelated third party
• The resale results in a gain
• The gain exceeds the disallowed loss from the original transaction

This provision ensures that the loss is not duplicated between taxpayers, but can be recaptured once an actual economic loss or gain is realized in an arm’s-length transaction.

Exceptions to Section 267

There are limited exceptions to the loss disallowance rule. In specific circumstances, losses may still be deductible even when related parties are involved. However, these exceptions are rare and subject to strict conditions.

Common Exceptions

• Transactions between unrelated partners within a partnership
• Liquidation of corporations under certain conditions
• Some estate or trust transactions with beneficiaries under IRS guidance

Taxpayers should consult with a qualified tax professional to determine whether a particular transaction qualifies for any exception under Section 267.

Tax Planning and Compliance Considerations

Because Section 267 can lead to unexpected nondeductible losses, careful planning is required before engaging in any transaction involving related parties. Both individuals and business owners must understand how these rules affect their tax positions to avoid penalties or audit issues.

Best Practices

• Document all transactions carefully, especially with family members or controlled entities
• Avoid selling appreciated or depreciated assets to related parties unless necessary
• Understand timing implications for basis recovery and resale
• Work with tax advisors to structure transactions properly

For business owners, internal controls should be established to monitor related-party activity and ensure proper reporting on tax returns and financial statements.

Nondeductible losses under Section 267 are a critical area of U.S. tax law that aims to prevent tax avoidance through artificial loss recognition in related party transactions. By disallowing these losses, the IRS ensures that only real economic losses are deducted for tax purposes. Taxpayers must be aware of who qualifies as a related party, how the rules apply, and the potential for loss recovery when the property is later sold to an unrelated third party. With thoughtful planning and a clear understanding of the rules, individuals and businesses can avoid unintended tax consequences and remain compliant with the law.