Troy is not a very astute investor. He has a knack for investing in losing stocks. In his latest investment move, he has realized a loss of about $40,000 (original basis of $50,000; current fair market value of $10,000) in High Tech, Inc. The good news is that unlike prior years, he actually has $45,000 of gains that he can use to offset the loss. Troy is considering either selling the High Tech, Inc. stock to his sister, Louise, or on the stock market. Which should he choose and why? Please explain why the IRS may treat the two transactions differently.
What will be an ideal response?
If Troy sells the stock to his sister, by tax law, he will not be able to deduct the loss. Thus, he should sell the stock on the stock market. The two transactions are treated differently because the sale on the stock market is considered an arm's length transaction whereas the sale to Louise is considered a related-party transaction.
In arm's length transactions, each transacting party negotiates for his or her own benefit. In contrast, taxpayers engaged in related-party transactions are much more willing to negotiate for the common good of the related parties and to the detriment of the IRS. Accordingly, the IRS pays special attention to related-party transactions (and even disallows losses in transactions involving related parties).
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