Fran Holloway is an active dealer in used automobiles. While preparing her income tax return, you notice that she purchased one automobile for $7,000 and sold it one month later for $5,800 to Brian Holloway Enterprises. Explain, in terms of the income tax concepts, why the $1,200 loss on the sale of the automobile may not be deductible.

What will be an ideal response?

If Fran and Brian Holloway Enterprises are related parties, the $1,200 loss on the sale would not be deductible. Because related parties are not deemed to transact at arm's-length, transactions between related parties are usually not given their intended tax effect. In addition, the substance-over-form doctrine would require the substance of the transaction to be recognized. If Fran and Brian are husband and wife (or brother and sister), the substance of the transaction would be a sale for $5,800 and a gift of $1,200.