The IRS often takes a close look at transactions between related parties because such transactions provide many opportunities for tax evasion. As a result, there are a number of rules that apply.

Generally, a C corporation is considered to be related to the following individuals and entities:

  • an individual who owns, directly or indirectly, more than 50 percent of the value of the corporation’s outstanding stock
  • another C corporation that is a member of the same controlled group
  • the fiduciary of a trust if the trust or trust grantor owns, directly or indirectly, more than 50 percent of the value of the corporation’s outstanding stock
  • a partnership if persons that hold more than a 50 percent capital or profits interest in the partnership also own more than 50 percent of the value of the corporation’s outstanding stock
  • an S corporation if persons that hold more than a 50 percent of the value of the S corporation stock also own more than 50 percent of the value of the corporation’s outstanding stock

Generally, a loss on the sale of property between related parties is disallowed. Moreover, gain on the sale of property between related parties may be treated as ordinary income rather than capital gain if the property is depreciable in the hands of the related purchaser. In addition, the installment sale generally may not be used to report gain on the sale of depreciable property between related parties.

Related parties that exchange like-kind properties may treat the exchange as a tax-free like-kind exchange only if they each hold the properties received in exchange for a period of two years from the date of the last transfer that was part of the exchange.

Other types of payments between related parties may also be subject to special rules. For instance, an accrual-basis corporation that makes payments to a related cash-basis taxpayer can only take a deduction for those expenses in the year that the related taxpayer includes those amounts in gross income.

Regulations under Code Sec. 385 recharacterize purported intra-group debt instruments as stock if the instrument is issued among highly related parties and does not finance new investment in the issuer’s operations, subject to certain exceptions for more ordinary course transactions.

The IRS may recharacterize a corporation’s payments to a related party as disguised dividends and disallow the corporation’s deductions of those amounts. It often takes this action when the corporation confers an economic benefit on a related party, primarily personal in nature, and there is no expectation of repayment.

In the case of two or more corporations that are members of the same controlled group, the IRS may distribute, apportion, or allocate gross income, deductions, credits, or allowances among the controlled corporations if it determines that this is necessary to reflect payment clearly or to prevent tax evasion.

If you would like to have a more detailed discussion about the related party rules and their application to transactions in which your corporation has been involved, please do not hesitate to call.