Related Entity: Definition, Transfer Pricing, and Disclosure

A related entity is any person, company, trust, or estate connected to another party by enough ownership, control, or family relationship that federal tax and accounting rules refuse to treat their dealings as independent. Most Internal Revenue Code provisions draw the line at more than 50% common ownership or when family members sit on both sides of a deal, though accounting standards can pull in a party at 20%. Once two parties fall inside the definition, losses on sales between them are disallowed, prices must reflect what strangers would pay, disclosures may be required, and the penalties for mispricing or nonreporting run into the millions.

How the Status Is Determined

Direct ownership is the simplest test. When one party holds more than 50% of the voting stock or value in a corporation, the two are treated as related for nearly every federal tax purpose, and that 50% line runs through most of the Internal Revenue Code’s related-party provisions covering partnerships, S corporations, and C corporations dealing with one another.¹

Accounting rules set a lower bar. Under generally accepted accounting principles, a 20% ownership stake creates a rebuttable presumption that the investor can exercise significant influence over the investee’s operations and financial decisions.² Even a minority investor can be a related party for financial reporting.

Control does not require a single share. An entity that can appoint the majority of another’s board, govern its operations through a contract, or direct its financial decisions may be treated as a controlling party regardless of equity. This de facto control matters most where a company depends heavily on one customer, supplier, or licensor. If one party can effectively dictate how another operates, the economic reality is the same as ownership even if the legal form looks different.

Family and Constructive Ownership

The tax code does not let you sidestep related-party status by putting stock in a relative’s name. Two separate attribution regimes treat you as owning what your family and your entities own, and they define “family” differently.

Section 267 Family

For the related-party loss rules, family includes your spouse, brothers and sisters (including half-siblings), ancestors, and lineal descendants such as children and grandchildren.¹ If your sister owns 60% of a corporation and you sell property to that corporation at a loss, the loss is disallowed because you and your sister are related for this purpose.

Section 318 Constructive Ownership

Section 318 uses a narrower family circle: spouse, children, grandchildren, and parents. Siblings are notably absent. But Section 318 chains ownership through entities. Stock owned by a partnership is treated as owned proportionately by each partner, and stock in a corporation that is at least 50% owned by one person is attributed to that person in proportion to their ownership.³ These chains stack: a spouse’s partnership interest can be attributed to you, and the partnership’s holdings can then be attributed onward.

The practical effect is that the IRS can trace ownership through layers of relatives and entities to find the true degree of control. A taxpayer who technically owns 30% of a company might constructively own 70% once spousal ownership and entity attribution are factored in.

Common Related Entity Structures

A parent company holding a controlling interest in another legal entity, called a subsidiary, is the most straightforward setup. The parent directs the subsidiary’s strategy, and the two are clearly related. Many large businesses operate through dozens or hundreds of subsidiaries, each its own corporation or LLC.

Brother-sister corporations exist when the same shareholders or a single individual control two or more companies. If the same person owns 60% of a restaurant chain and 70% of the real estate company that leases buildings to those restaurants, transactions between the two get related-party treatment.¹ The temptation to shift income between the two is obvious, which is why the IRS pays attention.

Affiliates are companies linked through common control by a third party without owning shares in each other. A private equity firm holding controlling stakes in a software company and a consulting firm creates an affiliate relationship between those portfolio companies. Accounting standards also treat trusts managed by company executives and pension funds run by company management as related parties, since the potential for self-dealing is built into the structure.

Tax Rules That Apply to Related Party Transactions

Losses Are Disallowed

Losses on sales or exchanges between related persons are disallowed in full. You cannot sell depreciated stock to your brother and claim the loss. You cannot sell a building to your wholly owned LLC at below-market value and deduct the difference. Section 267 lists 13 categories of related-person relationships that trigger this disallowance, covering family, trusts, estates, tax-exempt organizations, and various corporate combinations where the same interests own more than 50%.¹ The same rule applies to partnerships: losses on sales between a partner and their partnership are disallowed when the partner owns more than 50% of the capital or profits interest.⁴

Deductions Wait for the Related Payee

When an accrual-basis taxpayer owes money to a related cash-basis payee, the deduction is deferred until the payee actually receives and reports the income.¹ Otherwise a corporation could accrue a large management fee to its owner at year-end, deduct it immediately, and delay payment to the owner indefinitely, so the deduction and matching income would never land in the same year.

Gain on Depreciable Property Becomes Ordinary

Selling depreciable property to a related person converts what would normally be a capital gain into ordinary income.⁵ The buyer gets to depreciate the property again at the higher purchase price, generating new deductions; letting the seller also take capital gains rates would stack two benefits. Section 1239 taxes the seller’s gain at ordinary rates instead.

Like-Kind Exchanges Come With a Holding Period

Related parties can complete a Section 1031 like-kind exchange of real property, but both the property received by the related party and the replacement property received by the taxpayer must be held for at least two years after the exchange.⁶ If either side disposes of the property inside that window, the deferred gain becomes taxable as of the disposition date.

Transfer Pricing and the Arm’s Length Standard

When related entities exchange goods, services, or intellectual property, the prices must reflect what unrelated parties would agree to in an open market. Section 482 gives the IRS broad authority to reallocate income and deductions between commonly controlled businesses whenever their internal pricing doesn’t reflect economic reality.⁷ The statute reaches any combination of organizations, trades, or businesses under common ownership or control, incorporated or not, domestic or foreign.

Companies satisfy the standard by preparing transfer pricing studies that compare their intercompany pricing to comparable transactions between unrelated parties. The study documents the method used, the comparable transactions selected, and the economic analysis supporting the price. Intercompany agreements should spell out the specific goods or services provided, the pricing methodology, payment terms, and each party’s responsibilities. Vague or undocumented arrangements are easy targets on audit because they suggest the price was set for tax convenience rather than business reasons.

Disclosure Requirements

Under ASC 850, companies must disclose material related-party transactions, including the nature of the relationship, a description of the transactions, the dollar amounts, and any balances owed at the reporting date. The rule reaches affiliates, principal owners and their immediate families, company management and their immediate families, and any entity that can significantly influence the reporting entity’s operating policies.

Public companies face additional obligations. Under Item 404(a) of Regulation S-K, a company must disclose any transaction exceeding $120,000 in which a related person had a direct or indirect material interest. “Related person” here covers directors, executive officers, nominees for director, any shareholder owning more than 5% of the company’s stock, and the immediate family members of all of those individuals, defined to include spouses, children, stepchildren, parents, siblings, and in-laws, along with anyone sharing the household of a director or officer.⁸

Companies must identify the related person by name, describe their interest in the transaction, report the dollar value, and disclose the related person’s financial interest.⁸ For debt transactions, the disclosure requires the largest outstanding principal balance, amounts paid, and the interest rate.

Penalties for Getting It Wrong

Transfer Pricing

When the IRS adjusts income under Section 482 and the mispricing is large enough, a 20% accuracy-related penalty applies to the underpayment.⁹ This substantial valuation misstatement penalty applies when the reported price is 200% or more of the correct arm’s length price (or 50% or less), or when net Section 482 adjustments exceed the lesser of $5 million or 10% of gross receipts.¹⁰

The penalty doubles to 40% for gross valuation misstatements: distortions of 400% or more (or 25% or less), or net adjustments exceeding the lesser of $20 million or 20% of gross receipts.¹⁰ Contemporaneous documentation is the primary defense; the IRS can reduce or eliminate the penalty when the taxpayer shows a reasonable basis for its pricing.

Form 5472

Foreign-owned corporations doing business in the United States must report related-party transactions on Form 5472. A failure to file a timely and complete form triggers a flat $25,000 penalty per form, per tax year, with an additional $25,000 for every 30 days the failure continues beyond 90 days after IRS notice, uncapped.¹¹ A single-member LLC owned by a foreign person is also required to file, which catches many foreign investors off guard because they assume an LLC with no U.S. income has no filing obligations.

Handling Conflicts of Interest

When a director, officer, or controlling shareholder stands on both sides of a transaction, the conflict has to be managed formally or the deal risks being challenged. The standard approach: the interested person discloses the conflict and recuses themselves from the board’s discussion and vote. The remaining disinterested directors then evaluate whether the transaction is fair and in the organization’s best interest, and the minutes document the conflict, the recusal, and the reasoning behind the approval.

Courts look at whether the board genuinely evaluated alternatives, whether the interested party stayed out of the room during deliberations, and whether the price and terms were comparable to what an outside party would have accepted. For public companies, even a properly approved related-party transaction still needs to be reported if it exceeds the $120,000 threshold, and the proxy statement must describe the review and approval process the company followed.

1
Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers
2
Financial Accounting Standards Board. FASB Interpretation 35 – Criteria for Applying the Equity Method of Accounting
3
Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock
4
Office of the Law Revision Counsel. 26 USC 707 – Transactions Between Partner and Partnership
5
Office of the Law Revision Counsel. 26 USC 1239 – Gain From Sale of Depreciable Property Between Certain Related Taxpayers
6
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
7
Office of the Law Revision Counsel. 26 USC 482 – Allocation of Income and Deductions Among Taxpayers
8
eCFR. 17 CFR 229.404 – Transactions With Related Persons, Promoters and Certain Control Persons
9
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
10
Internal Revenue Service. The Section 6662(e) Substantial and Gross Valuation Misstatement Penalty
11
Office of the Law Revision Counsel. 26 USC 6038A – Information With Respect to Certain Foreign-Owned Corporations