– By Mark Battersby –
All too often unsuspecting rural building business owners find themselves facing penalties, fines and substantial tax bills because the ever-vigilant IRS has ignored a past transaction it views as having been conducted by “related persons.” Below-market rate loans, sales of property, installment sales, like-kind exchanges, intercompany transactions, etc. all may suffer from special tax treatment. Making things more difficult, there isn’t just one definition of “related persons,” “related parties” or “related taxpayers” to be found in our tax laws.
That’s right, different transactions have different definitions. In fact, related persons or parties can include much more than an immediate family member such as parents and children. Ancestors and lineal descendants, a partner and a partnership, a shareholder and a corporation, etc. are all considered “related” by the IRS. Sometimes indirect ownership, such as where an individual may be deemed to own an interest in a corporation merely because a brother owns shares is included.
Transactions between related persons are generally defined as a business deal or arrangement between two parties who are joined by a special relationship prior to the deal. An example would be a business transaction between a major shareholder and his or her business, such as the shareholder preparing tax returns for the building operation. Since both parties are “related” this would be deemed a transaction between related parties.
Although the majority of related-party transactions are acceptable, the special relationship inherent between the parties involved can create potential conflicts of interest. Thus, companies trading on the U.S. stock exchanges are required to disclose all transactions with related parties such as executives, associates and their family members. A similar view, involving more than stock transactions is taken by the ever-vigilant IRS.
Parents and grandparents often lend money to their children or grandchildren to help with major expenditures such as education, a wedding or the purchase of a new home. Similarly, a closely-held business may lend money to a shareholder-employee. And owners may lend money to their building business. All of these transactions are examples of related-person loans.
Not surprisingly, the IRS requires that loans be structured in a business-like manner with terms that reflect current market conditions. If the terms of a loan are too favorable in the view of the IRS, they can re-characterize the loan as a gift, additional compensation or as a corporate dividend or distribution with all the tax implications re-characterization implies.
For no-interest or below-market interest loans, the IRS can make adjustments to reflect the current “market” interest rate by requiring the lender to treat as income all interest, including the amount actually received under the terms of the loan as well as the difference between that amount and the current market interest rate. For tax purposes, the interest is calculated based on the Applicable Federal Rate (AFR).
The IRS publishes AFRs each month. They represent the minimum acceptable interest rates for the majority of loans. If the interest rate on a loan at its inception is equal to or exceeds the relevant AFR, the IRS cannot challenge whether the rate is appropriate during the term of the loan.
In general, if an employer lends an employee more than $10,000 at an interest rate that is less than the current applicable federal rate (AFR), the difference between the interest paid and the interest that should have been paid under the AFR is considered additional compensation to the employee. This rule also applies to loans of $10,000 or less if one of its purposes is tax avoidance.
A builder or contractor may plan to either sell property to, or acquire property from a family member or an affiliated business. Both parties are often surprised by the tax consequences. Quite simply, a loss on the sale or trade of property (other than a distribution when a corporation is completely liquidated) cannot be deducted if the transaction is between related entities such as:
- Members of the builder’s family. This includes brothers and sisters, half-brothers and half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).
- A partnership in which one party directly or indirectly own more than 50 percent of the capital interest or the profit interest.
- A corporation in which more than 50 percent of the outstanding stock is owned, directly or indirectly.
- Two S corporations if the same persons own more than 50 percent of the outstanding stock of each corporation.
- Two corporations that are members of the same controlled group (under certain conditions, however, these losses are not disallowed but must be deferred).
- Two partnerships if the same persons own, directly or indirectly, more than 50 percent of the capital interests or the profit interests in both partnerships.
Fortunately, our tax rules contain a special “non-recognition” rule for exchanges which require related parties exchanging property with each other to hold the exchanged property for at least two years following the exchange. If either party disposes of the property received in the exchange before the two-year period runs out, any gain or loss from the original exchange must be taken into account on the date the disqualifying disposition occurs.
Remember those loans to the building business? Whether loaning money as an investment to a college buddy starting a business, advancing funds to your business, or lending money to your brother for a new car, it is always wise to make sure the IRS will accept it as a bona fide debt. Otherwise, a loss cannot be claimed if the borrower defaults.
The IRS and the courts examine a number of things such as a written instrument, repayment terms, how the parties treat the transaction on their books, etc. But the IRS and courts also question whether a transaction, particularly a loan, is commercially feasible. That is, would an unrelated party advance money in the same situation?
Generally, losses from the sale of property between related parties mean the seller’s loss deduction will be disallowed. Of course, should the related-party purchaser subsequently sell the property at a gain, it is only the amount in excess of the previously disallowed loss that must be recognized on the operation’s annual tax return.
Even otherwise tax-free exchanges can be adversely affected where the parties are related. For example, if a builder or contractor exchanges property with a related person in a tax-free, like-kind exchange, the builder or contractor may be forced into recognizing gain if the related person disposes of the property exchanged within two years of the original transaction.
Where the builder’s or contractor’s transaction is part of a deferred exchange with an unrelated purchaser, if the qualified intermediary acquires the replacement property from a related person, the transaction will result immediately as a taxable event.
Our basic tax law is quite clear when it comes to transactions between “related persons,” demanding that any gain recognized be treated as ordinary income. So it is not surprising that the IRS requires that loans be structured in a business-like manner with terms that reflect current market conditions. Obviously, professional guidance is necessary for any builder or contractor hoping to avoid the tax laws’ related-persons pitfalls. RB
Mark Battersby has more than 35 years experience in small business issues, tax and financial matters. Contact him at 610-789-2480 or MCBatt12@Earthlink.net.