Does the IRS Scrutinize Transactions Between Family Members?
Does the IRS scrutinize transactions between family members? You bet they do! As a worst-case scenario, the IRS could set aside the transaction as if it never took place, which would mean whatever gain or loss you have, would evaporate.
There are plenty of reasons why the IRS will scrutinize a transaction between family members. Let’s face it – they are the IRS and their interest is to raise revenue. One reason that the IRS scrutinizes these transactions is because they are rarely “arms-length” transactions. Pricing is not established as if the buyer and seller are independent parties. With an “arm’s length” transaction, the seller must want to sell his or her property at a fair market price and the buyer must also offer a fair price. These transactions should not be for tax avoidance. The IRS will determine if the sale was fair, a gift or bogus and impose penalties.
The Internal Revenue Code is full of potholes for business deals between family members. The potholes could cost a business owner millions of dollars in taxes and can be avoided with careful planning. At the very least, knowing where they are gives you the chance to plan for them before you get the feared “90 day letter”.
Trying to claim a loss on the sale is usually disallowed as there are specific tax rules regarding a loss from the sale or exchange of property when it is between family members regardless of whether you can prove the price is fair. The IRS’s definition of family is very broad in this instance and includes brothers and sisters (even half-blood), spouses and direct ancestors and lineal descendants (including adopted children). Nieces and nephews, aunts, uncles and in-laws are excluded as are step-family members. The IRS is also likely to question you if you try to claim a gain on the sale if your return is audited. The IRS can claim that you didn’t recognize enough gain, hoping to tax the rest as a taxable gift. In selling property to a family member, you should keep a record of comparable prices in case the IRS audits your return.
The best approach is to plan that your transaction will be scrutinized by the IRS and to get professional advice before you act. Be prepared. Document every step of your related party transaction. All agreements should be in written format, and corroborating evidence should be retained. There is nothing wrong with engaging in financial transactions with family as long as all parties are aware of the possibility of added scrutiny. Be smart and properly prepare for such an event.
Above all, don’t try and be a “Zoomer” and do it yourself. The internet has created more travesties than all of the ponzie schemes combined. Those trained in the legal profession often point to a famous Abraham Lincoln quote when discussing pro se defendants: “The man who represents himself has a fool for a client.” Don’t be a fool.
Charles M. Farano J.D. LL.M Taxation Attorney at Law
Charles M. Farano has practiced law since 1979 and has his LL.M in Taxation from Loyola Law SchoolCharles is recognized as one of Southern California “Super Lawyer” consistently since 2008 and was recognized as one of America’s Top Ten Percent Attorneys in 2023