Most farmers and ranchers have extended family members who are also in the business and from time to time they likely do business with each other. What many might not realize is that doing business with a relative or “related person” actually has tax implications. Leases and equipment sales, for example, are treated differently if they are between related parties. So, who exactly does the IRS claim is a related person?
Who is a Related Person?
First and foremost the easiest part of the definition is family. For the IRS, family is a very long-reaching definition. Members of your immediate family include your spouse, kids, parents, brothers, sisters, half-brothers, half-sisters, ancestors, and lineal descendants. Ok, that one was easy.
What about an S-Corporation? That, by definition is its own legal entity, right? Yes, it is. It does not though, avoid the chance of being a related party. When looking at an entity, such as an S-Corporation, you have to look at direct and indirect ownership.
For example, if my brother is part owner in Farming-R-US, an S-Corporation, we have to look at his ownership percent level. If it is 80% or more, directly or indirectly, that makes a transaction between the S-Corporation and me a transaction to a related person in the eyes of the IRS. The same type of test also applies to tax-exempt educational or charitable organizations.
Transactions will be viewed as between related parties if direct or indirect control falls to a family member.
Example Tax Consequences for Related Party Transactions
Transactions between family members can be unavoidable at times. One of the more common instances is how a gain on sale or trade of depreciable property is treated. If it is a related party, that transaction might be treated as ordinary income, rather than capital gain, if it can be depreciated by the party receiving it.
Another common instance is with Like-Kind Exchanges. There are some exceptions, but if either party disposes of the “like kind” property within two years after the trade, both parties must recognize and report any gain or loss not recognized on the original trade. In cases of a loss on sale or trade to a related party, the deduction of the loss is entirely forfeited. Also, depreciable property purchased from a related party may not be eligible for Section 179.
This article is not designed to deter you from doing business with family. There are times when it may be the desired option for several reasons. Just understand that there will be certain implications from that transaction when filing your tax return. Knowing that there is a difference in treatment before completing the transaction gives you an opportunity to analyze the situation and discuss possible options with your tax preparer.