How to File a Non-Arm’s Length Transaction Disclosure

A non-arm’s length transaction disclosure is filed on whichever form matches the deal: Form 709 for a below-market gift or sale between individuals, Form 5472 attached to Form 1120 for a foreign-related corporate transaction, and a lender’s identity-of-interest disclosure if you’re financing a purchase from a relative with a mortgage. Each one asks you to identify the parties, describe the terms you actually agreed to, and show what an unrelated buyer or lender would have paid. Skip the filing or misstate the price and the penalties are steep: $25,000 per year for a missing Form 5472, and 20% to 40% of any tax underpayment when the reported price is far off market.

Are You Actually in a Related-Party Transaction

The IRS treats a transaction as non-arm’s length when the parties have a relationship that could influence the price. Section 267 defines “related parties” broadly. Family covers your spouse, parents, grandparents, children, grandchildren, and siblings (including half-siblings).¹

It also reaches into business structures. An individual and a corporation are related once the individual owns more than 50% of the corporation’s stock by value. Two corporations under common control, a trust and its grantor or beneficiary, a partnership and a corporation with overlapping ownership above 50%, and two S corporations with the same majority owners all qualify.¹

The threshold catches people off guard. Exactly 50% ownership isn’t enough; 50.01% is. But constructive ownership rules can push you over the line. Stock owned by your family members or by entities you hold a stake in gets attributed to you. Own 30% of a corporation while your spouse owns 25% and the IRS treats you as owning 55%.

Disclosing a Below-Market Loan

A family loan or a shareholder loan that charges little or no interest is one of the most common non-arm’s length arrangements. Section 7872 doesn’t ignore the missing interest. It treats the gap between what you charged and what the market would have charged as a taxable event.²

The benchmark is the Applicable Federal Rate (AFR), which the IRS publishes monthly for short-term, mid-term, and long-term loans.³ Charge below the AFR and the shortfall is “forgone interest.” On a gift loan between family members, that forgone interest is treated as transferred from lender to borrower (a gift) and then back from borrower to lender (interest income). The lender reports the imputed interest and may owe gift tax on the spread.²

There’s a de minimis escape. If the total outstanding loan balance between two individuals stays at $10,000 or less, Section 7872 doesn’t apply. It doesn’t help, though, if the borrower uses the money to buy income-producing assets like stocks or rental property.² The same $10,000 threshold covers loans between a corporation and a shareholder, but the exception vanishes if tax avoidance is one of the principal purposes.

To disclose the loan properly, keep the loan amount, the stated rate (if any), the AFR that applied when the loan was made, and the calculated forgone interest. The lender reports the imputed interest as income. If the forgone interest exceeds the annual gift tax exclusion, the lender files Form 709.

Disclosing a Below-Market Sale to Family

Sell property to a relative at a steep discount and the IRS treats the difference between the sale price and fair market value as a gift. Sell a $400,000 home to your daughter for $250,000 and you’ve made a $150,000 gift reportable on Form 709.⁴

For 2026, the annual gift tax exclusion is $19,000 per recipient.⁵ Gifts under that amount to any single person don’t require a return, but a discounted property sale almost always blows past it. Filing Form 709 doesn’t automatically mean owing tax. The lifetime exemption is $15,000,000 for 2026.⁶ The reportable gift chips away at that cap, and tax comes due only once the cap is exhausted. Where people run into real trouble is by not filing at all: the IRS has no statute of limitations on a gift tax return that was never filed.

Form 709 is due on the same date as your individual income tax return, so April 15 for most filers, or the extended date if you filed for an extension. On the return, describe the property, the sale price, the fair market value, and the relationship between you and the buyer. A qualified appraisal supporting the fair market value is the single most important piece of backup documentation.

Disclosing a Corporate or Foreign Related-Party Transaction

Section 482 gives the IRS broad power to reallocate income between related businesses if the prices they charge each other don’t reflect what unrelated companies would agree to. It applies to any two or more businesses under common ownership or control, incorporated or not, domestic or foreign. If the IRS finds the pricing between related entities doesn’t clearly reflect income, it can redistribute income, deductions, and credits between them.⁷

Form 5472

Any U.S. corporation that is at least 25% foreign-owned, or any foreign corporation doing business in the U.S., must file Form 5472 for each related party it transacted with during the year. The form captures the dollar value of every category of related-party transaction: sales, purchases, rents, royalties, interest, and service fees paid or received.⁸ File it as an attachment to Form 1120 on the same deadline.

This is the form most people underestimate. Single-member LLCs owned by a foreign person must file it too, even though they’re disregarded entities for other tax purposes. The requirement exists specifically to catch foreign-owned LLCs that used to fly under the radar.

Proving Your Prices Are Arm’s Length

The IRS expects proof that your related-party prices are arm’s length, and the regulations under Section 482 provide accepted methods for building that proof. The most common are the Comparable Uncontrolled Price method (comparing your related-party price to prices in similar unrelated transactions), the Resale Price method (working backward from the resale margin an independent distributor would earn), and the Cost Plus method (adding a market-rate markup to the supplier’s costs).⁹ The right method depends on the transaction type and the comparables you can find. Whichever you pick, the supporting documentation should be in place before the filing deadline, not pulled together after an audit starts.

Disclosing the Relationship to Your Mortgage Lender

Tax filings aren’t the whole picture if you’re buying property from a relative with a mortgage. Both FHA and conventional lenders have their own disclosure requirements, and they affect how much you can borrow.

FHA Loans

FHA calls these “identity-of-interest transactions” and caps the maximum loan-to-value at 85% for a principal residence. That’s a 15% down payment instead of the standard FHA minimum of 3.5%.¹⁰

The 85% cap has exceptions. It doesn’t apply if you’re buying the principal residence of a family member, or if you’ve been a tenant renting the property for at least six months before signing the purchase contract (with a lease to prove it). Builder employees purchasing a new model home and corporate relocation transfers are also carved out.¹⁰

Conventional Loans

Fannie Mae allows non-arm’s length purchases of existing properties but draws hard lines in two places. Delayed financing (buying with cash and immediately taking out a mortgage) is not permitted for non-arm’s length sales. And for newly constructed homes, Fannie Mae will only purchase loans secured by a principal residence if the borrower has any ownership interest, employment, or business affiliation with the builder or developer. Second homes and investment properties are excluded entirely.¹¹

The Appraisal

Whatever loan type applies, the buyer-seller relationship must be disclosed to the appraiser and noted on the appraisal report. Lenders read these appraisals harder because the risk of an inflated price is higher when the parties know each other. An independent, well-supported appraisal is your best defense against the loan being denied or the terms being tightened.

What to Have in Your File Before You File

Good disclosure starts long before the filing deadline. For any non-arm’s length transaction, you want:

Party identification: full legal names, addresses, and Taxpayer Identification Numbers (or EINs) for every entity or individual involved.
A description of the transaction: whether the deal involved tangible goods, intangible property (patents, trademarks, licenses), services, financing, or real estate. For loans, record the principal amount, repayment schedule, and stated interest rate.
The actual terms: the sale price, royalty rate, interest rate, or fee you agreed on. These are the figures the IRS compares to market benchmarks.
An arm’s length benchmark: what an unrelated party would have paid. For real property, a qualified appraisal. For corporate transactions, a transfer pricing study using one of the accepted methods. For loans, the AFR published for the month the loan was made.
Supporting contracts: intercompany agreements, loan documents, purchase contracts, and any amendments, in writing and dated before the transaction.

The gap between your actual price and the benchmark is the number the IRS focuses on. If your documentation can’t explain that gap, you’re inviting an adjustment.

How and When to File

Non-arm’s length disclosures ride along with your tax return, not separately. Corporate returns attach Form 5472 and related schedules to Form 1120. Individual gift tax returns go on Form 709, filed with or alongside Form 1040 by the same deadline. Electronic filing is standard, and the related-party forms transmit as part of the same package.

If you find that an original filing was incomplete or wrong, correct it with an amended return: Form 1120-X for corporations or Form 1040-X for individuals.¹² Corporations generally have three years from the original filing date, or two years from the date the tax was paid, whichever is later.¹³ Fixing a disclosure problem before the IRS finds it during an audit can reduce or eliminate penalties, so don’t sit on a known error.

Penalties for Getting It Wrong

The financial exposure here is not subtle. Form 5472 carries a flat $25,000 penalty for each related party for each tax year you fail to file or fail to maintain required records.¹⁴ If the IRS sends a notice and you still don’t fix it within 90 days, another $25,000 penalty applies for every 30-day period the failure continues after that 90-day window closes.⁸ A foreign-owned single-member LLC that ignores the form for two years can easily see six figures in penalties before anyone looks at the underlying tax.

On top of the filing penalties, the IRS imposes accuracy-related penalties when reported related-party prices are significantly off. A “substantial valuation misstatement” occurs when the transfer price you claimed is 200% or more of the correct arm’s length price, or 50% or less of it. It also triggers when net transfer pricing adjustments for the year exceed $5,000,000 or 10% of gross receipts. The penalty is 20% of the tax underpayment caused by the misstatement.¹⁵

If the distortion is extreme, meaning the price is 400% or more of the correct amount or 25% or less, it becomes a “gross valuation misstatement” and the penalty doubles to 40% of the underpayment.¹⁵ At that level the IRS often treats the whole transaction as suspect. An auditor may recharacterize an interest-free shareholder loan as a taxable dividend, or reclassify a discounted property sale as a capital contribution. Once the IRS decides the reported terms don’t reflect economic reality, the original deal structure stops mattering.

1
Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers
2
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
3
Internal Revenue Service. Applicable Federal Rates
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Internal Revenue Service. About Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return
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Internal Revenue Service. Frequently Asked Questions on Gift Taxes
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Internal Revenue Service. What’s New – Estate and Gift Tax
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Office of the Law Revision Counsel. 26 US Code 482 – Allocation of Income and Deductions Among Taxpayers
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Internal Revenue Service. Instructions for Form 5472
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eCFR. 26 CFR 1.482-1 – Allocation of Income and Deductions Among Taxpayers
10
U.S. Department of Housing and Urban Development. HUD Handbook 4000.1 – FHA Single Family Housing Policy Handbook
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Fannie Mae. Purchase Transactions – Fannie Mae Selling Guide
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Internal Revenue Service. About Form 1120-X, Amended US Corporation Income Tax Return
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Internal Revenue Service. Instructions for Form 1120-X
14
Office of the Law Revision Counsel. 26 USC 6038A – Information With Respect to Certain Foreign-Owned Corporations
15
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments