How Related Party Transactions and Loans Can Trigger IRS Scrutiny

In the realm of federal taxation, transactions between related parties often receive heightened scrutiny. The IRS enforces specific rules to prevent taxpayers from using related-party arrangements to manipulate income, deductions or timing advantages. Two primary areas where these rules apply are sales or exchanges between related parties and below-market or interest-free loans, which are subject to imputed interest under Internal Revenue Code §787.

Who Are Considered Related Parties?

Under IRC §267, related parties include close family members such as spouses, siblings, parents, children and grandchildren. It also encompasses certain business relationships; for example, a corporation and any individual owning more than 50% of its stock or partnerships and partners with significant interest. Constructive ownership rules apply, meaning relationships can be attributed through family or entity ties. Importantly, in-laws, cousins and ex-spouses are not considered related parties under this provision.

Sales or Exchanges Between Related Parties

When property is sold between related parties, losses are disallowed for tax purposes. This prevents taxpayers from creating artificial losses through non-arm’s-length transactions. However, gains are recognized and taxed normally. Special rules also apply to depreciable property. Any gain on the sale of such assets between related parties is taxed as ordinary income, not capital gain (IRC §1239).

Practically speaking, if a corporation sells an asset at a $3,000 loss to a sister company owned by the same individual, the loss is disallowed. If that sister company later sells the asset at a gain to an unrelated party, the original disallowed loss may be used to offset the gain, but only to the extent of the gain. If a loss results from the second sale, the original disallowed loss is forfeited.

Imputed Interest on Below-Market Loans (IRC §7872)

Loans between related parties often carry low or zero interest. To prevent tax avoidance, the IRS imputes interest — essentially treating interest as if it had been charged based on the applicable federal rate (AFR) published monthly.

The forgone interest (the difference between market rate and actual interest charged) is treated as a two-part transaction:

1. A deemed transfer of the forgone interest from the lender to the borrower (as a gift, dividend or compensation)
2. A deemed interest payment from the borrower to the lender

Tax Impact Depends on Relationship

The way imputed interest is taxed depends on who the loan is between. Even though no interest is actually paid, the IRS treats it as if it were, and that can affect both the lender and the borrower.

• Corporation-shareholder: Imputed interest treated as a dividend (nondeductible for the corporation, taxable to the shareholder)
• Employer-employee: Treated as compensation expense to the employer and wages to the employee
• Family loans: Result in interest income to the lender and interest expense to the borrower

De Minimis Exceptions to Imputed Interest

$10,000 Exception

No imputed interest applies if the total of all loans between the lender and borrower is $10,000 or less, unless the loan is used to purchase income-producing assets.

$100,000 Gift Loan Limitation

For gift loans under $100,000, imputed interest is limited to the borrower’s net investment income (NII). If NII is under $1,000, it is treated as $0, and no imputed interest is required.

Final Considerations for Related Party Transactions

Understanding the tax implications of related party transactions is essential for compliance and planning. The disallowance of losses on related-party sales and the imputation of interest on below-market loans are two mechanisms the IRS uses to prevent tax avoidance. While exceptions exist such as de minimis rules for small loans or limitations based on the borrower’s income, taxpayers must carefully document and consider the nature and purpose of each transaction. To learn more about Weaver’s accounting advisory services, contact us. We are here to help.

Authored by Tadeh Papelian

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