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Dealing with related party transactions

Dawn Drost Published on 09 August 2013

Many family farming and ranching operations have been in business for many years. It’s likely that Grandpa and Grandma started the original ranch years ago and passed it down to their children, who in turn have passed it down to their children.

At some point in time, additional land and livestock may have been purchased and placed in separate operating entities. Perhaps family members decided to go their own way and operations were split up and new businesses formed.

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Whatever the scenario, business transactions are taking place every day between related individuals and businesses, and depending on the transaction and the relationship between the parties involved, specific rules of the Internal Revenue Code need to be followed.

Just like when you were growing up, it was easier to get your brother or sister to do something for you than to get the kid down the road. After all, what are families for?

Congress figured out that it might be pretty tempting to shift income and expenses between related parties and thus reduce taxes or avoid them altogether.

Hence, rules were implemented to prevent related parties from receiving tax benefits not normally available when dealing with an unrelated entity or individual.

When related party issues arise, the first thing to do is to determine “who actually is a related party?” Related parties for tax purposes are defined in Internal Revenue Code Sections 267(b) and 1239.

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Which definition comes into play depends on what type of transaction is taking place. Under these code sections, related individuals for tax purposes are as follows: brothers and sisters (whether full or half blood), spouse, ancestors and lineal descendants.

So one’s grandparents on up and your children and grandchildren on down are considered related. So who does that leave out? Your in-laws, your aunts, uncles and cousins.

Defining who is a related individual is pretty straightforward, but defining a related business is much more complicated. Under code section 267(b), related parties include an individual and a corporation in which he or she owns more than 50 percent of the value of outstanding stock.

Ownership is determined by actual stock shares owned plus those shares considered owned by the individual indirectly due to familial relationships. An individual is considered to own what related family members own.

For example, if you and your three siblings each own 25 percent of a corporation, all of you are considered to indirectly own each other’s 25 percent. In other words, you are considered to indirectly own 100 percent of the corporation.

Indirect ownership rules are often referred to as the family attribution or constructive ownership rules. These rules also apply in determining indirect ownership of partnerships, LLCs and S-corporations. The above is a basic example of related parties within businesses.

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Determining related business relationships can be quite complex, and one should make a thorough reading of the code sections to understand all potential related parties to a business transaction.

Payments for goods and services are common related party transactions. The rule here is if the paying party is taking the expense deduction, then the receiving party is required to include the payment in gross income for the same tax period.

Assuming you are a year-end taxpayer, if you write a check to your brother for hay at the end of the year, but he doesn’t receive the check until January, he still must include the payment for hay in his gross income in order for you to take the expense deduction at year-end.

This rule applies whether the taxpayer is an accrual or cash-basis taxpayer and results in the matching of the expense deduction with the income recognition. Rent and interest payments are common examples of these types of payments.

In addition, the rent charged between related parties must be reasonable and a reflection of the going market rate being charged for rent.

This requirement is in place to prevent related parties from shifting income and deductions between each other solely to minimize taxes. In addition, the deduction for related party rent is limited to net income.

Another common transaction is the sale or exchange of property between related parties. Generally, a loss on the sale of property between related parties is disallowed for tax purposes.

However, if the related buyer eventually sells the property to an unrelated third party, the buyer may reduce the gain from this subsequent sale by the amount of the previously disallowed loss from the original related party sale.

So the original seller’s loss may eventually be recognized – but not by the original seller. That makes the original seller the “biggest loser.”

If the subsequent sale results in a loss rather than a gain, only the actual loss from the subsequent sale is recognized. The disallowed loss from the original related party sale is lost forever.

If you are selling depreciable property to a related party, then any gain from the sale or exchange is considered ordinary income rather than capital gain income.

The related party rules applicable to depreciable property are governed under code section 1239. Also, in a sale of depreciable property between related parties, the installment method of reporting the gain on the sale is generally not permitted.

Instead, all the payments are considered to have been received by the seller in the year of the sale, and the entire gain is taxable in the year of the sale.

However, if the related buyer is not going to treat the property as depreciable property, then the seller is permitted to use the installment sale method.

Farm business owners need to be aware of related party rules so they don’t find themselves in a transaction that has undesired tax consequences.

There are many intricate rules involved in related party transactions, and this article only touches on some of the more common ones. It is good to seek the advice of your tax adviser in any situation where you might be involved in a related party transaction. PD

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Dawn Drost
Tax Manager
Jones Simkins LLC

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