Friday, November 18, 2011

Related Party and Tax Deductions

If you are a partnership, LLC or S corporation and report on the accrual basis, this may apply to you.
You may be aware that there are restrictions on deductions between related accrual-basis and cash-basis entities or individuals. These are the “related party” rules of IRC Section 267 and are well-known to tax accountants. By the way, these rules drive on a one-way street: the effect is to delay the deduction, not to delay the income.
                EXAMPLE ONE:
Sanctuary, Inc is a C Corporation and accrual-basis taxpayer. It owes $34,000 at year-end to Sam (a Schedule C) for the provision of goods or services. Sam is a 51% shareholder.  Sam is on the cash-basis, as most individuals are. Sanctuary, Inc cannot deduct the $34,000 until Sam includes it in income, because more-than-50% ownership triggers the related party rule.

                EXAMPLE TWO:
Sam (a Schedule C) owes Sanctuary, Inc $27,000 at year-end for the provision of goods or services.  Sam (a Schedule C) cannot deduct this until it makes payment. Sam (a Schedule C) is, after all, on the cash-basis. Sanctuary, Inc is quite unruffled by all this. As an accrual-basis entity, it will report the $27,000 in income without waiting for Sam’s (a Schedule C) deduction.

The trap here is the more-than-50 percent rule. The 50% requirement goes away if the transaction is between an S corporation, partnership/LLC and a shareholder or partner/member.

Change Sanctuary to a partnership, LLC or S corporation and the threshold drops to any ownership. As an example, an accrual to a 2-percent S- corporation shareholder would be disallowed under the related party rules.

Why? Here is how I make sense of it. As a pass-through investor, both sets of numbers will wind up on one income tax return. The IRS is therefore stricter than it would be if the numbers wound up on two tax returns, such as between a C corporation and an individual.

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