By Mark E. Battersby
All-too-often unsuspecting pressure cleaning 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, there are different labels for different transactions. 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 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 transaction between a major shareholder and his or her business, such as a contract for the shareholder’s business to perform renovations to the offices of the pressure washing operation. Under our tax rules, this would be deemed a transaction between related-parties.
While the majority of related-party transactions are acceptable, the special relationship inherent between the involved parties can create potential conflicts of interest. Thus, companies trading on the U.S. stock exchanges are required to disclose all transactions with related parties. A similar view, involving more than stock transactions, is taken by the ever-vigilant IRS.
Parents and grandparents will 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 often lend money to their pressure cleaning businesses. All of these transactions illustrate the IRS’s views on 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 sight 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.
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 principal purposes is the avoidance of federal tax.
This additional compensation to the employee is subject to Social Security, Medicare, and FUTA taxes, but not to federal income tax withholding. It is included as compensation on the pressure cleaning business’s Form W-2 (or Form 1099-MISC for an independent contractor).
Often a pressure cleaning contractor or business will 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 or property (other than a distribution when a corporation is completely liquidated) cannot be deducted if the transaction is between entities considered related parties, such as:
• Members of the taxpayer’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 owns more than 50 percent of the capital interest or the profits interest.
• An incorporated pressure cleaning business 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 only deferred).
• Two partnerships if the same persons own, directly or indirectly, more than 50 percent of the capital or profit interests in both partnerships.
Fortunately, our tax rules contain a special “non-recognition” rule for ex-changes, 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 pressure washing business owner will sell to an unrelated party and receive replacement property from a related party. According to the IRS, this type of related party transaction does not work if the related party receives cash. The IRS reasons that 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. However, if the related party is also doing an exchange (and is not “cashing out”), then it is okay to receive replacement property from a related party according to the IRS.
And then, there are sales to a related party with replacements provided by an unrelated party. A pressure washing business will sell to a related party but receive replacement property from an unrelated party. This is okay, but it is unclear whether the related party is required to hold the property acquired from the taxpayer for two years.
Some, but not all IRS guidelines seem to imply that the two-year rule applies. Tax professionals generally advise their clients to comply with the two-year rule although several rulings by the IRS clearly state that the two-year rule does not apply to a related party who purchased the relinquished property from the taxpayer.
Remember those loans to the pressure cleaning business? Whether loaning money as an investment to a college buddy starting a business, advancing funds to your pressure washing operation, 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 factors, such as is the transaction in writing, its repayment terms, how it’s treated on their books, etc. Most of these factors can be documented to meet the requirements. Of course, the IRS and courts may 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 an otherwise tax-free exchange can be adversely affected where the parties are related. For example, if a contractor exchanges property with a related person in a tax-free, like-kind exchange, the pressure washing contractor 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 pressure cleaning business’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.
Our basic tax law, the Internal Revenue Code is quite clear when it comes to “related persons,” demanding that any gain recognized be treated as ordinary income (taxable, in the case of an individual, at a maximum rate of 39.6 percent). So, it is not surprising that the IRS requires all transactions to be structured in a business-like manner with terms that reflect current market conditions. Obviously, professional guidance is necessary for any contractor or pressure cleaning business owner hoping to avoid the tax laws’ related-persons pitfalls.