A non-arm’s length transaction is a deal between two parties who already have a relationship, such as family members, a shareholder and their corporation, or a parent company and its subsidiary, that could influence the price or terms away from what strangers would agree to on the open market.1The IRS and other regulators treat these transactions with automatic suspicion because the parties may set prices that don’t reflect what a stranger would pay on the open market. When the price strays from fair market value, the IRS has broad authority to rewrite the deal, impute income or gifts that never actually changed hands, disallow losses, and add accuracy penalties of 20% to 40% on the resulting underpayment.
The benchmark the IRS applies is the arm’s length standard: the price a willing buyer and willing seller, neither under compulsion and both reasonably informed, would agree on. Two strangers haggling over a used car produce that price automatically because each is pushing for their own best deal. Once a pre-existing relationship removes that tension, the transaction falls under heightened scrutiny and the burden shifts to the parties to prove their price was reasonable.
Who Counts as a Related Party
Section 267 of the Internal Revenue Code lists 13 categories of related persons, and landing in any one of them subjects your transaction to related-party treatment regardless of whether the price was actually manipulated.
Family Members
For tax purposes, your family includes your spouse, siblings (including half-siblings), parents, grandparents, children, and grandchildren. A sale of investment property between two brothers is automatically a non-arm’s length transaction. The statutory family definition does not on its own include aunts, uncles, cousins, or in-laws, though constructive ownership rules can pull them in through business interests.
Constructive ownership is where the rules reach further than most people expect. Under Section 267(c), you are treated as owning any stock held by your family members. If your daughter owns 60% of a company, the IRS treats you as owning that stock too, so any deal between you and that company is a related-party transaction. The attribution also runs through partnerships, estates, and trusts, where interests are treated as owned proportionately by the partners or beneficiaries.
Businesses and Entities
A parent company and its subsidiaries are related because they share common control. Two corporations form a brother-sister controlled group when five or fewer people own more than 50% of the voting power or total stock value of both. Section 267(b) also covers deals between a corporation and a partnership with overlapping ownership above 50%, between a grantor and a trust’s fiduciary, between a fiduciary and a beneficiary of the same trust, between an individual and a tax-exempt organization they control, and between an estate’s executor and a beneficiary.
The existence of the relationship alone is enough. The IRS never has to prove the parties actually schemed to bend the price.
What the IRS Can Do to the Deal
When a related-party transaction is priced away from fair market value, the IRS does not merely flag it. It can rewrite the economics. If a parent sells stock worth $100,000 to a child for $10,000, the agency will treat the deal as a $100,000 sale combined with a $90,000 gift. Both parties then owe tax as if amounts had moved that never actually did.
The recharacterization authority comes from IRC Section 482, which lets the IRS redistribute income, deductions, credits, or allowances between organizations, trades, or businesses under common control whenever necessary to prevent tax evasion or to clearly reflect income. The statute is deliberately broad, covering incorporated and unincorporated businesses, domestic and foreign entities, and affiliated and unaffiliated groups alike.
Section 267 adds a separate rule that stings even more directly: losses on sales between related parties are flatly disallowed. You cannot sell depreciated stock to your brother, claim the loss on your return, and let him hold the stock going forward. The loss simply disappears for tax purposes.
Family Real Estate Sales
Selling a home or investment property to a family member is the most common non-arm’s length scenario people run into, and it is where the gift tax rules bite hardest. Sell a $500,000 house to your child for $100,000 and the IRS treats the $400,000 difference as a gift.
Most people won’t actually owe gift tax on that transfer. Each person can give up to $19,000 per recipient in 2026 without filing anything. Beyond that annual exclusion, each person has a $15 million lifetime gift and estate tax exemption for 2026, so cumulative taxable transfers below that amount produce no gift tax due. But you still must file Form 709 to report gifts that exceed the annual exclusion, even when no tax is owed.
The loss disallowance rule under Section 267 also applies here. Sell property to a sibling for less than what you paid, and the loss is gone. This rule exists specifically to stop taxpayers from manufacturing losses by transferring depreciated assets to someone in their orbit.
A related arrangement worth knowing is the gift of equity, where a family member sells the home below market value and the difference counts as the buyer’s down payment. If a parent’s home appraises at $300,000 and they sell it to their child for $250,000, the $50,000 spread is a gift of equity the child can apply to down payment and closing costs. Fannie Mae permits this for primary residence and second home purchases, and the loan file needs a signed gift letter and a settlement statement reflecting the equity gift.
Below-Market Loans
Lending money to a family member or a shareholder at zero interest looks harmless, but the IRS treats it as two transactions: a loan at the market rate plus a gift (or, in a corporate setting, a distribution) of the interest that should have been charged. IRC Section 7872 governs this territory.
The minimum rate you must charge is the Applicable Federal Rate, which the IRS publishes monthly. AFRs come in three tiers: short-term for loans of three years or less, mid-term for loans over three years up to nine years, and long-term for loans over nine years. If your stated rate falls below the AFR, the difference is imputed as interest income to the lender and, for a gift loan, as a gift from lender to borrower.
Two thresholds soften the rule for smaller loans:
- If the total outstanding balance between two individuals stays at or below $10,000, the imputed interest rules don’t apply at all. The same $10,000 floor covers compensation-related and corporate-shareholder loans.
- For gift loans between individuals with balances between $10,001 and $100,000, imputed interest for income tax purposes is capped at the borrower’s net investment income for the year. If that net investment income is $1,000 or less, it’s treated as zero, which effectively eliminates the imputation. This break disappears if one of the loan’s principal purposes is tax avoidance.
Once the aggregate balance passes $100,000, the full AFR applies to the entire balance. The best protection is a written promissory note with the loan amount, an interest rate at or above the AFR, a repayment schedule, and signatures, treated exactly as a bank would treat it. Without that paper, the IRS can reclassify the whole “loan” as a gift, or in the corporate context as a constructive dividend.
Excessive Compensation and Constructive Dividends
When a closely held business pays a related person more than the market rate for their work, the IRS can recharacterize the excess as a constructive dividend. The distinction matters because salary is deductible by the corporation and subject to employment taxes, while a constructive dividend is not deductible by the corporation but still taxable to the shareholder. The company loses the write-off and the shareholder still owes the tax.
The same logic applies to inflated management fees paid to a related holding company. Anything above what an independent firm would charge for comparable services can be recharacterized. The IRS weighs the employee’s qualifications, the nature and scope of the work, the size and complexity of the business, prevailing pay for comparable positions, and the company’s dividend history. A company that pays generous salaries but never declares dividends is a favorite target, because the pattern suggests the salary is a disguised distribution.
Penalties for Getting the Price Wrong
The accuracy-related penalty under IRC Section 6662 imposes a 20% penalty on underpayments attributable to a substantial valuation misstatement, and 40% for a gross valuation misstatement. The thresholds depend on the type of transaction.
For property valuations, a substantial misstatement occurs when the claimed value is 150% or more of the correct amount, and a gross misstatement begins at 200% or more. For transfer pricing, a substantial misstatement occurs when the claimed price is 200% or more (or 50% or less) of the arm’s length price, with the gross misstatement threshold at 400% or more (or 25% or less). A substantial misstatement also exists when the net Section 482 adjustment exceeds the lesser of $5 million or 10% of gross receipts; the gross threshold is $20 million or 20% of gross receipts.
These penalties apply only when the underpayment attributable to valuation misstatements exceeds $5,000 for individuals and S corporations, or $10,000 for C corporations. Most meaningful related-party transactions clear that floor easily. And you cannot dodge the valuation misstatement penalty by disclosing the position on Form 8275; the instructions specifically exclude misstatements attributable to non-arm’s length prices from the disclosure safe harbor.
Protecting the Transaction
The burden of proof in any related-party transaction falls on the taxpayer, not the IRS. Documentation needs to exist before the deal closes, not after an audit letter arrives.
For real estate and other asset transfers, get an independent appraisal from a certified appraiser. It establishes fair market value and becomes your primary defense if the price is questioned. For business interests, use a qualified business appraiser working from recognized methods such as discounted cash flow or comparable transactions.
For loans, put a written promissory note in place with the AFR (or higher), a repayment schedule, and signatures. Send payments through traceable accounts, and have the lender report the interest income.
Corporate transfer pricing carries its own documentation regime under the Section 482 regulations. The taxpayer must maintain contemporaneous documentation, meaning it exists at the time the return is filed, identifying the pricing method chosen, explaining why it was the most reliable, and providing the supporting data. The IRS gives you 30 days to produce it on request, and having it ready is a prerequisite for avoiding the enhanced Section 6662(e) penalties.
Foreign-owned U.S. corporations face an extra reporting layer. Any U.S. corporation that is at least 25% foreign-owned must file Form 5472 to report related-party transactions during the tax year, and foreign-owned U.S. disregarded entities file a pro forma Form 1120 with Form 5472 attached. The obligation runs under Sections 6038A and 6038C.
Safe Harbors That Keep Small Transactions Clear
Not every related-party transaction creates tax friction. The code builds in exceptions that keep routine transfers from becoming compliance problems.
The annual gift tax exclusion lets you give up to $19,000 per recipient in 2026 without filing a gift tax return or touching your lifetime exemption. Married couples can combine their exclusions for $38,000 per recipient. That covers many everyday family transactions where the below-market element is modest.
For gifts above the annual exclusion, the $15 million per person lifetime exemption for 2026 means no gift tax is actually due until cumulative taxable transfers pass that figure. Reporting on Form 709 is still required for gifts over the annual exclusion, but reporting is not paying.
The $10,000 de minimis rule under Section 7872 eliminates imputed interest for small loans between individuals, and the $100,000 threshold caps imputed interest at the borrower’s net investment income for gift loans under that balance. These thresholds apply per lender-borrower pair, so a parent lending $10,000 to each of three children has three separate loans, each inside the de minimis limit.