Converting Capital Gains into Ordinary Income: Related Party Pitfalls

The tax code is very much like a desert in that it can offer mirages to the unwary. One of the ways this occurs is by transforming what otherwise could be a favorable transaction into one that is much less favorable. Today we’ll take a look at one such provision in § 1239. Section 1239 converts any gain recognized by a seller on the sale of property to ordinary income if the property is able to be depreciated by the buyer if they are considered related parties.
§ 1239 defines related persons for this purpose as the following:

1. A person and all entities controlled by that person. A controlled entity for this purpose means

• a corporation in which a person owns, directly or indirectly, more than 50% of the value of the outstanding stock;
• a partnership in which a person owns, directly or indirectly, more than 50% of the capital interest or profits interest; and
• any entity that is a related person under items 3, 10, 11, or 12 of I.R.C. § 267(b)

2. A taxpayer and any trust in which the taxpayer (or spouse) is a beneficiary, unless the beneficiary’s interest is a remote contingent interest, as defined in I.R.C. § 318

3. An executor and beneficiary of an estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest

4. An employer (and any person related to the employer) and a welfare benefit fund controlled by the employer or a person related to the employer

Let’s take a look at an example where Sally and Suzie, mother and daughter, milk cows together in a small partnership. This will focus on 1(b)’s requirement above. Sally has also been operating a dairy farm as a sole proprietor. As Sally nears retirement, she decides to sell her cows to Suzie. The sale is for $30,000. Because Suzie is eligible to depreciate those raised cows, Sally will have to recognize ordinary income under the sale.

Typically, the sale of raised cows receives capital gains treatment and is taxed at much lower rates. However, in this case Sally and Suzie are considered related parties regardless of each of their ownership percentages in the partnership, as the ownership of each of them is attributable to the other. If Sally were a single taxpayer with $120,000 of adjusted gross income (AGI) and $30,000 of raised cow sales, she would pay $4,500 in tax on the cows (15% capital gains rate). However, if that same amount were treated as ordinary income, in the 24% tax bracket, her federal tax increases to $7,200 (without factoring in section 199A’s deduction).

Sally’s $2,700 increase is one of many pitfalls present in the tax desert. Prior to making that journey, Sally should have been informed of the consequences by a diligent tax professional.

Agricultural businesses are subject to a variety of tax laws such as this one, and non-specialized advisers and tax preparers may not be familiar with agricultural deductions, allowances, penalties and special requirements. Farm Credit East tax professionals are trained to help you capture every deduction the law allows. Visit FarmCreditEast.com/taxplanning to learn more.