Business Tax Preparation · Advising the business taxpayer

Related party transactions

The disallowance rules — IRC § 267, § 707(b), § 1239 and § 1031(f) — are set out under analysis of financial records. This page is the advisory side: what a preparer should say before the transaction, when the question is still how to structure and price it rather than what to do about it afterwards.

The rule

The Service can reprice. where two or more organizations, trades or businesses are owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion or allocate gross income, deductions, credits or allowances among them if that is necessary to prevent evasion of taxes or clearly to reflect income^TY2026 (IRC § 482), against the standard in the standard applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer — a controlled transaction meets it if its results are consistent with what uncontrolled taxpayers would have realised in the same transaction under the same circumstances, judged by comparable transactions and the best method rule^TY2026 (Reg. § 1.482-1(b)(1)). Note the breadth: whether or not incorporated, whether or not organised in the United States, whether or not affiliated. Two businesses under common control are enough.

Compensation must be reasonable and earned. the deduction for compensation is limited to a reasonable allowance for salaries or other compensation for personal services *actually rendered* — so the payment must be both reasonable in amount and for services in fact performed^TY2026 (IRC § 162(a)(1)).

And a failed deduction does not simply disappear. an amount a C corporation pays a shareholder that is not deductible compensation, rent or interest is a distribution — a dividend to the extent of earnings and profits, then a reduction of stock basis, then gain from the sale of the stock^TY2026 (IRC § 301(c); IRC § 316). In an S corporation the mirror problem runs the other way — too little compensation, recharacterised into wages with employment tax.

A partner dealing with the partnership may be outside it. where a partner engages in a transaction with the partnership other than in the capacity of a member, the transaction is treated as occurring between the partnership and a non-partner^TY2026 (IRC § 707(a)(1)), and two anti-abuse rules follow: a performance of services or transfer of property by a partner, coupled with a related allocation and distribution to that partner, is recharacterised where the two viewed together are properly a transaction between the partnership and a non-partner^TY2026 (IRC § 707(a)(2)(A)) and a transfer of money or property by a partner to the partnership, coupled with a related transfer back to that partner or another, is treated as a sale or exchange where the two viewed together are properly characterised that way^TY2026 (IRC § 707(a)(2)(B)).

Renting to yourself is asymmetric. gross rental income from property rented for use in a trade or business in which the taxpayer materially participates is treated as *not* passive, up to the net rental income from that property — so the income cannot absorb passive losses, while a rental loss on the same property stays passive^TY2026 (Reg. § 1.469-2(f)(6)).

Current figures

How it works in practice

Advise on character before amount. A related-party payment usually moves money that was going to move anyway; what the tax system cares about is what the payment is. Rent, interest, compensation and distribution have different deductibility, different employment tax treatment and different consequences for basis and for the passive activity rules. Getting the amount slightly wrong costs an adjustment. Getting the character wrong costs the deduction, the payroll treatment and sometimes both.

Reasonable compensation runs in opposite directions in the two entity types. A C corporation overpays its owner-employee to convert non-deductible dividends into deductible salary, and the exposure is the excess being treated as a distribution under IRC § 301(c) — not deductible, and taxable to the shareholder as a dividend to the extent of earnings and profits. An S corporation underpays to avoid employment tax, and the exposure is a recharacterisation into wages. Same statutory phrase, opposite incentives, so ask which way the client’s incentive points before looking at the number.

Document the comparables while the transaction is being priced. The arm’s length standard is comparative, and the comparison is very hard to reconstruct years later. A lease at market rent supported by two contemporaneous agents’ letters is almost unassailable; the same rent with no file is a negotiation.

Watch the sequence in a partnership. The § 707(a)(2) rules are about linked steps: a contribution followed by a distribution, or services followed by an allocation and distribution. Neither is caught in isolation. What makes them dangerous is that the linkage is judged on substance, so a genuine two-year gap and a genuine business reason matter more than the labels on the documents.

Self-rental is the most common planning error in this topic. Renting a building to a company in which the owner materially participates converts the rental income to non-passive under Reg. § 1.469-2(f)(6), so it cannot absorb passive losses from anywhere else. But a rental loss on the same property remains passive. The asymmetry means the arrangement is worse than either a purely passive or a purely active one, and it catches owners who set the rent to break even and then find a repair year turns the position against them.

IRC § 482 does not require a foreign element. The provision reaches any two or more businesses under common control, domestic or not, incorporated or not, and it is regularly applied to a pair of commonly owned domestic companies shifting income between a profitable one and one with losses or credits about to expire.

Scenarios

Traps

How this has changed

IRC § 482 has been in essentially its present form since 1928, and the arm’s length standard in Reg. § 1.482-1(b)(1) has been the governing test throughout. What has changed is the machinery around it: the best method rule replaced the old priority of methods in 1994, and the documentation and penalty regime under IRC § 6662(e) now makes contemporaneous analysis effectively compulsory for larger transactions rather than merely prudent.

The § 707(a)(2) rules arrived in 1984 in response to arrangements that used the flexibility of subchapter K to convert sales into contributions and distributions, and the disguised sale regulations under § 707(a)(2)(B) have been repeatedly revised since — most recently around the treatment of liabilities, where the boundary between a genuine leveraged distribution and a disguised sale has moved more than once. A preparer should check the current regulations rather than rely on a remembered rule.

The self-rental rule has not changed, but its consequences have grown. IRC § 461(l), made permanent by Pub. L. 119-21 § 70601(a) and indexed for the first time in 2026, adds a further limitation after the passive activity rules, so a self-rental arrangement now sits inside a longer chain of limitations than it did.

Nothing in the post-2024 legislation alters IRC § 482, § 162(a)(1) or § 707(a)(2).

Exam focus

Know that IRC § 482 reaches purely domestic groups and that the standard is the arm’s length standard applied by comparison, under the best method rule.

For reasonable compensation, know the statutory phrase — a reasonable allowance for compensation for services actually rendered — and be able to say what happens to the disallowed portion in each entity type. In a C corporation it is a distribution under IRC § 301(c); in an S corporation the problem is the reverse and the remedy is wage recharacterisation.

Keep the two § 707(a)(2) rules apart: (A) is services or property followed by a related allocation and distribution, (B) is a transfer to the partnership followed by a related transfer back.

The self-rental rule is the likeliest single question. State it precisely: gross rental income is non-passive up to the net rental income from that property where the property is rented for use in an activity in which the taxpayer materially participates — income only, never loss.

Finally, remember the division of labour between this topic and the disallowance rules. Questions asking what happens to a loss on a sale belong to IRC § 267 and § 707(b); questions asking whether a price or a structure will hold belong here.

Check yourself

1. Two commonly owned domestic corporations, one profitable and one with expiring credits, transact at prices favouring the second. Neither has any foreign operations. Is IRC § 482 available to the Service?

Answer: Yes. IRC § 482 applies to two or more organisations, trades or businesses owned or controlled directly or indirectly by the same interests, and says in terms that it applies whether or not incorporated, whether or not organised in the United States, and whether or not affiliated. The Secretary may allocate income, deductions, credits or allowances among them where necessary to prevent evasion of taxes or clearly to reflect income — and shifting income to absorb expiring credits is a paradigm case.

2. An S corporation shareholder-employee who runs the business full time takes no salary and $180,000 of distributions. What is the exposure?

Answer: Recharacterisation of some or all of the distributions as wages. IRC § 162(a)(1) presupposes that compensation for services actually rendered is paid, and the arrangement pays none for services that are plainly being rendered. The consequence is employment tax on the recharacterised amount, with the employer and employee shares plus penalties and interest. Note the direction: unlike a C corporation, where the risk is excessive compensation converted into a distribution, the S corporation risk runs from distribution to wages.

3. A taxpayer materially participates in an operating company and rents it a building at a rent producing $25,000 of net rental income. He has $60,000 of passive losses from other activities. How much can he offset?

Answer: None of it against this income. Reg. § 1.469-2(f)(6) treats gross rental income from property rented for use in a trade or business in which the taxpayer materially participates as not from a passive activity, up to the net rental income from that property — so the whole $25,000 is non-passive and the passive losses cannot reach it. They remain suspended until he has passive income from elsewhere or disposes of the loss activity in a fully taxable transaction.

4. A partner transfers equipment to a partnership and, six weeks later, receives a distribution of an amount close to the equipment’s value, funded by a loan the partnership took out to make it. The documents describe a contribution and a distribution. How is it analysed?

Answer: Under IRC § 707(a)(2)(B). There is a transfer of property by a partner to the partnership, a related transfer of money back, and the question is whether the two viewed together are properly characterised as a sale or exchange. The short interval, the closeness of the amounts and the borrowing taken out to fund the distribution all point that way, and the documents’ labels do not control. If it is a sale, the partner recognises gain and the partnership takes a cost basis, rather than the carryover treatment a contribution would give.

5. Why is contemporaneous documentation worth more in this topic than in most?

Answer: Because the tests are comparative and about intent, and both decay. The arm’s length standard asks what uncontrolled parties would have done in comparable circumstances, which requires evidence of the market as it stood at the time; reasonable compensation asks what the services were worth then; and the § 707(a)(2) rules ask how linked steps are properly characterised, which turns on the business reason for each. A compensation study, a market rent letter or a board minute written at the time is evidence of the very thing in issue. The same document reconstructed later is argument.