What Are the Tax Rules for Related Entities?

When individuals or businesses have close relationships, the Internal Revenue Service (IRS) applies special tax rules to their transactions. These “related entities” or “related parties” are subject to specific regulations designed to prevent the artificial shifting of income or losses to gain a tax advantage. Because these parties do not operate at arm’s length like unrelated entities would, the tax code imposes safeguards to ensure transactions reflect true economic substance.

Identifying Related Parties

The Internal Revenue Code (IRC) Section 267 provides the framework for identifying related parties. These rules categorize specific relationships where transactions receive special scrutiny, covering a wide range of personal and business connections. The nature of the relationship, not the intent behind a transaction, is what triggers these classifications.

A primary category of related parties involves family members. The tax code is specific about which relatives are included: spouses, siblings (including half-brothers and half-sisters), ancestors such as parents and grandparents, and lineal descendants like children and grandchildren. It is important to note that in-laws, uncles, aunts, and cousins are not considered related parties under this definition.

Another common related party scenario involves an individual and a corporation. An individual is considered related to a corporation if they own more than 50% of the value of the company’s outstanding stock, either directly or indirectly.

The rules also extend to relationships between different business entities. For instance, two corporations are considered related parties if they are members of the same controlled group. Other defined relationships include a grantor and a fiduciary of a trust, a fiduciary of a trust and a beneficiary of that trust, and a person and a tax-exempt organization that is controlled by that person or their family.

The Concept of Constructive Ownership

The tax rules for related parties incorporate the principle of constructive ownership, also known as attribution. This concept treats a taxpayer as owning stock or interests legally owned by another person or entity, preventing circumvention of the rules by distributing ownership among relatives or controlled entities. Constructive ownership effectively expands the 50% ownership test for many related party transactions.

Under family attribution rules, an individual is considered to own the stock that is owned by their family members. The definition of family is the same as for the direct relationship test. For example, if a taxpayer’s son owns 20% of a corporation and their father owns 40%, the taxpayer is treated as constructively owning 60%, making them a related party.

Stock owned by a corporation, partnership, estate, or trust is treated as being owned proportionately by its shareholders, partners, or beneficiaries. If a partnership in which an individual has a 50% interest owns 100 shares of a company, that individual is treated as owning 50 of those shares.

Conversely, the rules can attribute ownership from an owner to an entity. Stock owned by a partner or a shareholder can be attributed to the partnership or corporation if that individual has a controlling interest. These attribution rules work together to create a comprehensive picture of economic interest, ensuring that the substance of ownership is considered over its legal form.

Key Tax Consequences of Related Party Transactions

Transactions between related parties trigger several tax consequences, including the disallowance of losses on the sale or exchange of property. If a taxpayer sells an asset to a related party for less than its adjusted basis, the resulting loss cannot be deducted. For example, if an individual sells land with a basis of $100,000 to their wholly-owned corporation for $70,000, the $30,000 loss is disallowed.

A special rule applies if the related party who acquired the property later sells it at a gain. The previously disallowed loss can be used to reduce the gain recognized on the subsequent sale. In the prior example, if the corporation later sells the land to an unrelated person for $110,000, its recognized gain is $40,000. This gain can be offset by the original $30,000 disallowed loss, resulting in a taxable gain of only $10,000.

Another rule involves the matching of income and deductions between related parties who use different accounting methods. If an accrual-basis taxpayer owes an expense to a related cash-basis taxpayer, the accrual-basis taxpayer cannot deduct the expense until the day the payment is made and the cash-basis taxpayer includes the amount in their gross income. This prevents the payor from taking a deduction for an expense that the related payee has not yet recognized as income.

Gains on the sale of depreciable property between certain related parties can also be recharacterized. If depreciable property is sold to a related party, any gain recognized on the sale may be treated as ordinary income rather than a more favorably taxed capital gain. This rule, found in IRC Section 1239, applies to sales between a person and their controlled entities.

Special Rules for Controlled Groups

Beyond the transactional rules, a specific set of regulations governs controlled groups of corporations. A controlled group is a set of two or more corporations connected through common ownership. The tax code defines several types, with the most common being parent-subsidiary groups and brother-sister groups, each with its own stock ownership tests.

A parent-subsidiary controlled group exists when a parent corporation owns at least 80% of another corporation. A brother-sister controlled group involves two or more corporations where five or fewer individuals, estates, or trusts meet two tests. They must collectively own at least 80% of each corporation and have more than 50% identical ownership across the companies.

The primary tax implication for a controlled group is that its members are often treated as a single taxpayer for certain tax benefits and limitations. This prevents business owners from splitting a single enterprise into multiple corporations simply to multiply tax advantages.

This single-taxpayer treatment extends to other areas. The accumulated earnings credit must be divided among the members of the group. Similarly, the annual Section 179 expense deduction limit applies to the entire controlled group, not to each individual corporation. These rules ensure that tax benefits are not improperly claimed by larger, affiliated corporate structures.