August 15, 2022
Corporations and related parties are in a position to provide or receive undue advantage in a transaction, and they may be viewed as distinct from ordinary transactions because they may deprive other shareholders of dividends or capital gains. This article will describe how related party transactions are treated.
What is a related party?
A related party is a person who has a certain relationship with a corporation or its officers. A C corporation is considered related to the following individuals or entities.
Parent company, subsidiaries, and affiliates.
An individual who owns directly or indirectly more than 50 percent of the value of the corporation's outstanding stock.
Another corporation if the two are members of the same controlled group.
A fiduciary of a trust if the trust or a trust grantor owns directly or indirectly more than 50 percent of the value of the corporation's outstanding stock.
A partnership if the same persons own more than 50 percent of the value of the corporation's outstanding stock and more than 50 percent of the capital or profits interest in the partnership.
An S corporation if the same persons own more than 50 percent of the value of both corporations' outstanding stock.
Selling Loss Property to a Related Party
Losses on sales or exchanges of property between related parties are disallowed. However, the buyer of the property in the related party sale or exchange in which the seller's loss was disallowed may reduce the amount of any gain recognized on a subsequent sale of the property by the amount of the previously disallowed loss. A corporation may potentially be subject to this loss disallowance rule if the other party is an individual or an entity that is considered related to the corporation as a result of an actual and constructive ownership of stock in the corporation. This loss disallowance rule applies even in the case of a bona fide, valid sale or exchange of property at fair market value.
Selling Depreciable Property to a Related Party
A corporation's gain from the sale or exchange of property to a related person may also be treated as ordinary income if the property is depreciable in the hands of the related purchaser. This rule applies whether the related purchaser actually claims depreciation or amortization.
Using the Installment Method for Related Party Sales
Another set of rules disallows the use of the installment method for reporting gain from the sale of depreciable property between related persons. In such cases, a corporation must treat the installment payments as received in the year in which the depreciable property is sold.
Selling Property Received in Like-Kind Exchange with Related Party
A corporation and a related party that exchange like-kind properties enjoy nonrecognition treatment on the exchange only if they hold the properties received in the exchange for a period of two years after the date of the last transfer that is part of the exchange. If either party disposes of the property received in the exchange within the two-year period, it must consider any gain or loss recognized on the exchange in the year of the disposition.
Matching Deductions with Income Recognition
Unlike losses on transactions between related parties, expense deductions for amounts paid between related parties are not disallowed. However, an accrual-basis corporation can only deduct expenses owed to a related cash-basis taxpayer as of the day the amount paid is includible in the gross income of that taxpayer.
Paying Constructive Dividends and Deducting Payments Made by Shareholders
The IRS may determine that a corporation has paid a constructive dividend to a shareholder if the corporation confers an economic benefit on a shareholder without any expectation of repayment and the benefit to the shareholder is primarily personal in nature. In such cases, the corporation may not claim a deduction for the payment of these expenses. In other instances, a corporation may deduct shareholder's advances to the corporation that are used by the corporation to pay corporate business expenses.
Allocating Income and Deductions Between Related Corporations
If two or more corporations are owned or controlled directly or indirectly by the same interests, the IRS may distribute, apportion, or allocate gross income, deductions, credits, or allowances among such corporations if it determines that this is necessary to prevent tax evasion, or to clearly reflect the corporations' income.
Allocating Items Between a Personal Service Corporation (PSC) and its Shareholders
Companies that provide services in professional fields such as consulting, engineering, accounting, are classified as personal service companies (PSC), and the IRS may also allocate income and tax benefits between a PSC and its employee-owners in certain cases to prevent tax avoidance or evasion or to clearly reflect the income of the PSC and its employee-owners.
When there are related party transactions such as these, various restrictions and rules are imposed, and they can be complicated. Companies should be mindful of properly handling related party transactions rules and consider proper bookkeeping and preparing financial statements.
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