Related Party Transactions
A related party transaction refers to a deal or an arrangement between two parties who are joined by a preexisting business relationship or common interest. Although related party transactions are themselves legal, they may create conflicts of interest or lead to other illegal situations.
Examples of related party transactions:
- Management Service Agreements
- Related Party Loans
- Related Party Lease Agreements
Related Party Transactions Should:
- Be An Arm’s Length Transaction
- Be documented in a written agreement
An arm’s length transaction in one where both the buyers and the sellers act independently without one party influencing the other. In dealing with related party transactions, the terms should be similar to an arm’s length transaction.
All related party transactions should be documented in a written contract. Written contracts:
- Documents the agreement about services to be rendered and payment obligations
- Prevents misunderstanding from arising regarding the agreed upon terms
- Provides security and peace of mind. A written contract gives ample protection for the parties involved with the agreed terms or conditions are not followed or are breached
- Guaranteed Confidentiality. A written contract can provide for confidentiality and nondisclosure provisions for sensitive information
- Avoid expensive litigation proceedings if the contract is breached.
- Serves as an official record of the business agreement.
Common Related Party Transaction Problems
Common problems with related party transactions include:
- No written contract documenting the terms of the transaction.
- Written contract exists but the terms of the agreement are not followed
- Loan documents do include interest or it includes a below market interest rate and may not include payment terms
Common Related Party Transaction Problems
Related party transactions can have unintended tax consequences.
Without a written document,
- How do you prove what services/goods were being provided?
- How do you prove what the agreed upon prices?
- How do you prove what the payment terms are?
IRS Tax Treatment of Related Party Transactions
If you do not provide sufficient evidence of the agreement, whether written or a verbal agreement, the IRS will have no option other than to:
- Limit interest deductions
- Disallow Management Deductions
- Disallow Lease Deductions
Related Party Best Practices
- Get all related party transactions documented in writing
- Follow the terms of the agreement.
- Loans Need to Include Adequate Interest