All-too-often unsuspecting snow removal and ice management 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” 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.
DEFINING RELATED PARTY TRANSACTIONS
Transactions between related persons can generally be defined as a business deal or arrangement between two parties who are joined by a special relationship prior to the deal. One example would be a business transaction between a major shareholder and his or her snow removal business, such as a contract for the shareholder's building business to perform renovations to the offices of the snow removal operation. Under our tax rules, this would be deemed a transaction between related parties.
While many related-party transactions are perfectly acceptable, the special relationship inherent between involved parties can create potential conflicts of interest. Thus, companies trading on the stock exchanges are required to disclose all transactions with related parties such as executives, associates and their family members. A similar requirement, involving more than stock transactions, is taken by the ever-vigilant IRS.
LOANS AT ARM’S LENGTH
Parents and grandparents may lend money to children or grandchildren to help with expenditures such as education, a wedding or the purchase of a new home. Similarly, a closely held business may lend money to an owner, shareholder or employee. Owners and shareholders will sometime lend money to their business. All of these transactions are examples of related-person loans.
Not surprisingly, the IRS requires 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 eyes of the IRS, they can recharacterize the loan as a gift, additional compensation or as a corporate dividend or distribution – with all the tax implications recharacterization 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.
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.
A snow removal contractor may sell to an unrelated party and receive replacement property from a related party. According to the IRS, this related party transaction does not work if the related party receives cash. If a taxpayer or a related party “cashes out” of property in this manner the tax rule "kicks in" and the exchange will be disallowed. If, however, the related party is also doing an exchange (and is not "cashing out") then it is permissible to receive replacement property from a related party.
IS IT REAL?
Remember those loans to the snow removal and ice management business? Whether lending money as an investment to a college buddy starting a business, advancing funds to your own 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. Most of these factors can be documented to meet the requirements. 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?
Losses from the sale of property between related parties usually means the deduction for the seller’s loss will be disallowed in the year of sale. Of course, should the related-party purchaser subsequently sell the property at a gain, only the amount in excess of the previously disallowed loss must be recognized for tax purposes.
Even an otherwise tax-free exchange can be adversely affected where the parties are related. For example, if a snow removal operation exchanges property with a related person in a tax-free, like-kind exchange, the business may nevertheless be forced into recognizing gain if the related person disposes of the property exchanged within two years of the original transaction. Where the snow removal operation’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 in an immediately taxable event.
And then, there are sales to a related party with replacement from an unrelated party. A snow business will sell to a related party but receive replacement property from an unrelated party. This is OK but it has been unclear whether the related party is required to hold the property it acquired from the taxpayer for two years.
Some, but not all IRS guidelines imply the two-year rule applies. Tax professionals generally advise clients to comply with the two-year rule although several rulings by the IRS clearly state the two-year rule does not apply to a related party who purchased the relinquished property from the taxpayer.
Our basic tax law, the Internal Revenue Code is quite clear when it comes to transactions between “related persons” demanding that any gain recognized be treated as ordinary income (taxable, in the case of an individual, at a maximum rate of 37%). Remember, the IRS requires loans be structured in a business-like manner with terms that reflect market conditions. So professional guidance is needed to avoid the tax law’s related-party or related-persons pitfalls.