Section 267 Related Party Rules: What You Need to Know

Tax laws prevent businesses and individuals from using related-party transactions to manipulate income, deductions, or losses for tax advantages. Section 267 of the Internal Revenue Code specifically limits how taxpayers can recognize certain expenses and gains when dealing with related parties. Understanding these rules is essential for avoiding disallowed deductions, unexpected tax liabilities, and compliance issues.

Types of Related Parties

The IRS defines related parties broadly to prevent taxpayers from structuring transactions to manipulate taxable income. These relationships extend beyond immediate family members to include various business entities and ownership structures.

Family relationships commonly trigger related-party rules under Section 267. This includes parents, children, siblings, grandparents, grandchildren, and spouses. Transactions between married individuals and their closely held businesses may also be subject to these restrictions.

Business ownership is another key factor. A corporation and an individual shareholder are considered related if the shareholder owns more than 50% of the company’s stock, directly or indirectly. Indirect ownership occurs through attribution rules, where stock owned by family members or entities under common control is treated as owned by the taxpayer. Partnerships, S corporations, and trusts are also subject to these rules, with ownership thresholds varying by entity type.

Attribution rules further expand the definition by treating stock or partnership interests owned by certain entities as if they were owned by individuals. If a parent owns 60% of a corporation and their child owns 10%, the IRS may consider the child as owning the parent’s shares for tax purposes. This prevents taxpayers from shifting ownership among family members or related entities to bypass restrictions.

Transactions Subject to These Rules

Certain transactions between related parties are restricted under Section 267 to prevent tax avoidance schemes that distort taxable income. One major limitation applies to the deduction of expenses. When one related party incurs an expense payable to another, the deduction may be deferred until the recipient recognizes the corresponding income. This prevents taxpayers from accelerating deductions while delaying taxable income.

Sales of property between related parties are also affected. If a taxpayer sells an asset to a related entity at a loss, Section 267 disallows the recognition of that loss. This prevents artificially generated deductions from underperforming assets within a controlled group. However, if the related party later sells the asset to an unrelated third party at a gain, the previously disallowed loss may offset that gain, deferring rather than eliminating the tax impact.

Loan transactions face scrutiny as well. When a related party lends money without charging adequate interest, the IRS may impute interest income based on applicable federal rates. This prevents taxpayers from avoiding taxable interest income by structuring loans with artificially low or no interest. If the loan is deemed a gift or equity contribution rather than a true debt obligation, it may be reclassified as a dividend or capital contribution, triggering additional tax consequences.

Timing for Deductions and Income

The timing of deductions and income recognition in related-party transactions is regulated to prevent mismatches that distort taxable income. Under Section 267(a)(2), if an accrual-basis taxpayer incurs an expense payable to a related cash-basis recipient, the deduction cannot be taken until the recipient includes the income.

This rule frequently impacts businesses with intercompany transactions, particularly those involving management fees, royalties, and rent payments. For example, if an accrual-method corporation records a $100,000 management fee owed to its sole shareholder, who reports income on a cash basis, the deduction is delayed until the shareholder receives the payment.

Employee compensation and bonuses paid to related parties also fall under these timing restrictions. While businesses can generally deduct salaries when accrued, payments to a related individual must be included in their taxable income before the deduction is allowed. This primarily affects closely held corporations where owners take compensation in various forms, including deferred bonuses. If a company accrues a year-end bonus for an owner-employee but does not pay it until the following year, the deduction is postponed until the recipient reports it as income.

Treatment of Gains or Losses

When related parties exchange assets, the tax treatment of gains or losses diverges from standard rules to prevent artificial tax benefits. Gains on sales between related entities remain taxable, but the IRS scrutinizes these transactions for potential mispricing or disguised distributions. If a property transfer occurs below fair market value, the difference may be reclassified as a gift, dividend, or compensation, triggering additional tax consequences. For example, if a parent sells a rental property to a child at a significant discount, the IRS may treat the undervaluation as a partial gift, requiring the seller to file a gift tax return and potentially reducing the child’s future depreciation deductions.

Depreciation recapture rules further complicate these exchanges. Under Sections 1245 and 1250, when depreciable property is transferred between related parties, any gain attributable to prior depreciation deductions is taxed at ordinary income rates rather than capital gains rates. This prevents taxpayers from converting ordinary income into preferentially taxed long-term capital gains. If a business owner sells fully depreciated equipment to a related entity, the recaptured amount is taxed at rates up to 37%, rather than the lower 20% maximum capital gains rate.

Documentation Requirements

Proper documentation is necessary for related-party transactions to ensure compliance with Section 267 and avoid IRS disputes. Records must support the legitimacy of transactions, demonstrate adherence to fair market value, and provide evidence that income and deductions are reported correctly. Without adequate documentation, the IRS may recharacterize transactions, disallow deductions, or impose penalties.

Contracts and agreements should clearly outline the terms of related-party transactions, including pricing, payment schedules, and interest rates if applicable. For example, if a business leases property from a related entity, a formal lease agreement should specify the rental terms and demonstrate that the rate aligns with market conditions. Transfer pricing studies may also be necessary for intercompany transactions to justify pricing structures and avoid IRS adjustments. Maintaining records of payments, invoices, and correspondence helps substantiate that transactions were conducted at arm’s length and not structured solely for tax benefits.