Related-Party Transaction: Definition and Tax Rules

A related-party transaction is any sale, exchange, lease, loan, or service arrangement between parties whose relationship — defined by family ties, ownership percentages, or common control — gives the IRS reason to scrutinize whether the terms reflect economic reality or instead shift income, accelerate deductions, or defer gains in a way that would not occur at arm's length. The Internal Revenue Code addresses related-party transactions through multiple overlapping provisions, each with its own definition of "related," its own consequences, and its own method of computing the resulting tax distortion.

Who Qualifies as a "Related Party"

The IRC defines "related party" differently depending on the transaction at issue:

  • IRC §267 treats the following as related parties for purposes of loss disallowance and deferred deductions: (a) family members (siblings, spouse, ancestors, and lineal descendants); (b) an individual and a corporation in which the individual owns, directly or constructively, more than 50% of the value of outstanding stock; (c) a fiduciary and a beneficiary of the same trust; and (d) two corporations that are members of the same controlled group. Constructive ownership rules under IRC §267(c) attribute stock owned by partnerships, corporations, estates, and trusts to their owners, and attribute stock owned by family members to each other.

  • IRC §1239 applies a broader definition — "related persons" include an individual and any corporation more than 50%-owned (directly or indirectly) by that individual, and two corporations in a controlled group. This provision converts what would otherwise be capital gain into ordinary income when depreciable property is sold between related persons.

  • IRC §707(b) governs partnerships and treats a partner owning more than 50% of capital or profits as related to the partnership, and two partnerships with more than 50% common ownership as related to each other.

  • IRC §482 applies the arm's-length standard to transactions between commonly controlled businesses: if the IRS determines that the amounts charged for goods, services, or intangibles do not reflect what unrelated parties would negotiate, it may reallocate gross income, deductions, and credits between the related entities to reflect arm's-length pricing.

Key Tax Consequences

Loss disallowance (IRC §267(a)(1)). Losses on sales or exchanges between related parties are permanently disallowed. If the buyer later sells the property at a gain, the gain is reduced (but not below zero) by the previously disallowed loss. The suspended loss does not carry over to unrelated purchasers — it expires unused if the related buyer ultimately sells at a price below the original seller's basis.

Deferred deductions (IRC §267(a)(2)). An accrual-basis taxpayer cannot deduct expenses owed to a related cash-basis payee until the payee includes the amount in income. This prevents the common maneuver of a corporation deducting an accrued bonus or management fee at year-end while the controlling shareholder-employee receives — and reports — the cash in a later year.

Ordinary income on depreciable property (IRC §1239). Gain on a sale of depreciable property between related persons is treated as ordinary income to the seller, regardless of how long the asset was held. This prevents related parties from engineering capital gain treatment by shifting depreciated assets while retaining the economic benefit of the depreciation through ownership of the buyer.

Installment sale restrictions (IRC §453(e)). When a related party acquires property on the installment method and resells it before all installment payments have been received, the original seller is treated as having received the amount realized on the resale — the so-called "second disposition" rule accelerates gain recognition. See Installment Sale for the mechanics of gross profit ratio reporting.

Imputed interest (IRC §7872). Below-market loans between related parties — including shareholder loans and family loans — are recharacterized as if market-rate interest were charged, with the forgone interest treated as a gift, dividend, or compensation depending on the parties' relationship.

How CPAs Use This in Practice

Related-party rules surface throughout entity-level planning. In S-corporation shareholder basis analysis, loans from shareholders must be bona fide debt — back-to-back or circular loans structured to create artificial basis can be recharacterized. In holding company structures, intercompany management fees, rent, and interest must be priced at arm's length to avoid §267 disallowance or §482 reallocation. For earnouts and contingent sale proceeds, the second-disposition rules under §453(e) require CPAs to track related-party resales that could accelerate the original seller's deferred gain. Disclosure of related-party transactions is also required on Form 1065 (Schedule B), Form 1120S (Schedule B), and in audited financial statements under ASC 850.

Related Terms

  • Installment Sale — the default gain-deferral method restricted by the second-disposition rule for related-party sales
  • At-Risk Rules — related to the limits on deductible losses from pass-through entities
  • S-Corp Shareholder Basis — where related-party loan characterization directly affects loss limitations
  • Holding Company Structures — intercompany transactions that must satisfy arm's-length standards
  • Constructive ownership — the IRC §318 rules that attribute stock ownership among family members and entities, expanding the related-party net beyond direct ownership