Category: Partnerships & LLCs; Accounting Periods & Methods
Subject: Sale of Dealer Notes
Title: Sale of Dealer Notes Between Related Parties
IRC Sections: 1221(4), 267(a)(1) and 707(b)
Filename: 1255.html
Date Produced: 07/95

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
Taxpayer (TP) and son are each 50% partners in a general partnership (PAPER) engaged in the business of purchasing installment contracts from used car dealers. TP wants to invest in a used car dealer which will then sell its contracts to PAPER.

Because installment reporting is not available for inventory sales, a dealer must immediately recognize 100% of the profit from each contract. Contracts can generally be sold for around 50% of face value. Since a dealer has basis in the contract equal to its face value (by virtue of having already recognized all the gain associated with the contract), selling the contract for 50% of face produces a loss. Under Section 1221(4), the loss is ordinary because the contract in the hands of the dealer is not a capital asset. The ordinary loss on disposition of the contract partially offsets the profit recognized by the dealer from the used car sale.

This methodology allows the dealer to free up cash while minimizing the tax consequences resulting from lack of installment sale treatment.

Section 267(a)(1) and 707(b) provide that losses resulting from property sales between certain related parties are deferred. If either provision applies to the losses intended to be claimed on disposition of the installment notes, the tax result described above would be destroyed because the offsetting loss from the sale of the contracts would be deferred, and the dealer would be forced to recognize 100% of the profits from sales of used cars.Issue
What is TP's maximum stake in the used car dealer?

Answer
TP can own no more than 50% the used car dealer. The maximum ownership is the same no matter whether the dealer is a C corporation, an S corporation, a partnership, or an LLC.

Discussion
Section 267(a)(1) and 707(b) provide that losses resulting from property sales between certain related parties are deferred. The related parties to which these rules apply are defined in Sections 267(b) and 707(b). The relationships relevant to this fact pattern (assuming PAPER remains a partnership or an LLC treated for tax purposes as a partnership) are as follows:

-a corporation and a partnership if the same persons own more than 50% of the value of the outstanding stock of the corporation and more than 50% of the capital interest or the profits interest in the partnership; [Section 267(b)(10)] and

-two partnerships in which the same persons own more than 50% of the capital interests or the profits interests. [Section 707(b)(1)(B).

In general, constructive ownership of stock or partnership interests counts for purposes of these rules as though the stock or the partnership interest were actually owned by the taxpayer in question. Accordingly, the 50% maximum ownership discussed above includes both direct as well as indirect ownership of the dealer entity. Great care should be exercised to take into account the application of the constructive ownership rules of Section 267 in determining TP's ownership of the dealer entity for purposes of these rules.