Non-Arm’s Length Transactions: IRS Rules, Losses, and Penalties

A non-arm’s length transaction has tax consequences that a market-priced deal does not: the IRS can disallow your loss, convert your capital gain into ordinary income, treat the bargain element as a gift or a dividend, impute interest you never received, reallocate income between businesses you control, and layer on accuracy-related penalties of 20 to 40 percent. The rules apply whether or not you intended a tax benefit, and whether or not you thought the price was fair. Fair market value and contemporaneous documentation are what separate a defensible related-party deal from an expensive one.

Who the IRS Treats as a Related Party

The definition reaches further than most people expect. For individuals, related parties include your spouse, parents, grandparents, children, grandchildren, and siblings (including half-siblings). For business entities, the general threshold is more-than-50-percent common ownership: a corporation is related to any person who directly or indirectly owns more than half its stock, and a partnership is related to anyone owning more than half its capital or profits interest.¹

Trust relationships are also covered. A grantor and a trustee, a trustee and a beneficiary, two trusts with the same grantor, and an executor and an estate beneficiary all count as related. So do tax-exempt organizations controlled by an individual or that individual’s family.¹

Watch the constructive ownership rules. Stock held by family members and by entities you have an interest in is attributed back to you. If your spouse owns 40 percent of a corporation and you own 15 percent directly, you are treated as owning 55 percent, and any sale between you and that corporation is a related-party transaction even though your direct stake was well under the threshold.

Losses You Cannot Deduct

Sell property at a loss to a related party and the loss is permanently disallowed to you. It does not matter that the price genuinely reflected fair market value or that the sale had a legitimate business purpose. The seller gets no deduction.¹

The buyer receives a limited consolation. When the buyer later sells the property to an unrelated third party at a gain, that gain is recognized only to the extent it exceeds the loss originally disallowed to the seller. The benefit is tied to the specific property. If the buyer eventually sells at a loss instead, the original disallowed loss simply disappears; nobody gets to deduct it.

Selling the asset to an unrelated buyer first and then having a family member acquire a replacement is cleaner in theory, but if the two steps are prearranged the IRS can collapse them into a single related-party sale under the step-transaction doctrine. Substance controls over form when family members appear on both sides of transactions completed in close succession.

When Capital Gain Becomes Ordinary Income

Selling depreciable property to a related party turns every dollar of gain into ordinary income, regardless of how long you held the asset. The rule applies whenever the buyer can depreciate the property after the purchase.²

The rate spread is real. Long-term capital gains cap out at 20 percent for most taxpayers, while ordinary income can be taxed at rates up to 37 percent. A business owner who sells equipment, a building, or a patent application to a controlled entity expecting capital gain treatment will pay ordinary rates on the entire gain.²

For this rule, related persons include a taxpayer and any entity they control by more than 50 percent, a taxpayer and a trust in which the taxpayer or spouse is a beneficiary, and an executor and an estate beneficiary. Constructive ownership applies, so indirect ownership through family or entities can push you over the threshold without your realizing it.

Bargain Sales Are Gifts

When you transfer property to another person for less than fair market value, the difference is a taxable gift, even if you had no intention of making one.³ A parent who sells a $500,000 house to their child for $200,000 has made a $300,000 gift, no matter what either party thought they were doing.

The annual gift tax exclusion covers $19,000 per recipient in 2026 with no filing required. Anything above that counts against your lifetime exemption, which sits at $15,000,000 per person for 2026.⁴ You will not owe gift tax until your cumulative lifetime gifts exceed the exemption, but you do have to file Form 709 for any year a gift to one recipient tops the annual exclusion.⁵

In the house example, the parent files Form 709 reporting the $300,000 gift and applies $281,000 of lifetime exemption. No tax comes due at that point, but the shelter available at death shrinks by that amount. Because the IRS measures the gift against fair market value rather than the price the family agreed to, a qualified independent appraisal of any non-cash property transferred between family members is effectively mandatory.

Below-Market Loans and Imputed Interest

Interest-free or below-market loans between family members, between an employer and employee, or between a corporation and a shareholder are not tax-free. The IRS treats the lender as having gifted the unpaid interest to the borrower, and treats the borrower as immediately paying that interest back. The lender owes income tax on interest never received; the borrower may have received a taxable gift or compensation.⁶

The benchmark is the Applicable Federal Rate, which the IRS publishes monthly in short-term, mid-term, and long-term versions matched to loan durations. Any loan charging less than the applicable AFR triggers the imputed interest rules.⁷

Two exceptions help smaller family loans:

Gift loans between individuals are fully exempt from the imputed interest rules on any day the total outstanding balance between the two people stays at or below $10,000. This exception is lost if the borrower uses any of the proceeds to buy income-producing assets like stocks or a rental property.⁶
For gift loans between individuals with a total balance at or below $100,000, the imputed interest income the lender must report is capped at the borrower’s net investment income for the year. If that net investment income is $1,000 or less, it is treated as zero and no interest is imputed at all. The cap does not apply if tax avoidance was a principal purpose of the loan.⁶

Income Reallocation Between Commonly Owned Businesses

When two or more businesses share common ownership, the IRS can reallocate income, deductions, and credits among them to reflect what each would have earned dealing at arm’s length. The authority applies whether the businesses are incorporated or not, domestic or foreign, affiliated or independent.⁸

The IRS determines the correct price by asking what unrelated parties would have charged in a comparable situation. Taxpayers are expected to use whichever pricing method produces the most reliable answer, drawing from comparable uncontrolled prices, comparable uncontrolled transactions for intangibles, comparable profits methods, and profit-split methods.

Constructive Dividends

If a corporation sells property to a shareholder below fair market value, the IRS can recharacterize the discount as a constructive dividend. The shareholder recognizes income equal to the bargain element, and the corporation gets no deduction. The same treatment applies when a shareholder uses corporate property without paying full value or receives services at below-market rates.

Related-Party Rent

Leases between related parties, common when a business owner holds real estate in one entity and operates through another, must reflect what an unrelated tenant would pay for comparable space. Rent that is too low lets the IRS impute additional rental income to the landlord. Rent that is too high limits the tenant’s deduction. Square footage, location, building condition, lease term, and local vacancy rates all matter. A professional appraisal or independent market study at the time the lease is signed provides the strongest support.

Buy-Sell Agreements in Family Businesses

Closely held businesses often use buy-sell agreements to fix the price at which a deceased owner’s interest will be purchased. When the owners are family members, the IRS presumes the price does not reflect real market value and can ignore it entirely for estate tax purposes.

The IRS will disregard the agreement’s price unless it meets all three of these tests:

The agreement is a bona fide business arrangement.
The agreement is not a device to transfer the business interest to family members for less than adequate consideration.
The terms are comparable to what unrelated persons would agree to at arm’s length.⁹

Fail any one of the three and the IRS revalues the interest at date-of-death fair market value. The estate then owes tax on the higher figure even if it is contractually obligated to sell at the lower agreement price. The gap between the tax owed and the sale proceeds can starve the estate of cash.

Foreign-Owned Businesses: Form 5472

Related-party transactions that cross a U.S. border trigger a separate reporting layer. A 25-percent-foreign-owned U.S. corporation must file Form 5472 to report the nature and amounts of its related-party transactions. A single-member LLC that is 100 percent foreign-owned must file as well, even if it has no U.S. income.

The form does not itself create a tax liability, but the penalty for each failure to file a complete and correct Form 5472 by the deadline is $25,000. If the IRS sends a notice and the form still is not filed within 90 days, another $25,000 accrues for every 30-day period, or fraction of one, that the failure continues. There is no cap.¹⁰ A few years of missed filings can produce penalties that dwarf any tax at stake.

Penalties for Getting Valuation Wrong

Accuracy-related penalties on related-party valuations are structured in two tiers. For property valuations on income tax returns, a substantial valuation misstatement exists when the claimed value is 150 percent or more of the correct value; the penalty is 20 percent of the tax underpayment caused by the misstatement. A gross valuation misstatement, where the claimed value reaches 200 percent or more of the correct value, doubles the penalty to 40 percent.¹¹

Transfer pricing adjustments between related businesses have their own triggers. A 20 percent penalty applies when the net transfer pricing adjustment exceeds the lesser of $5 million or 10 percent of the taxpayer’s gross receipts. It rises to 40 percent when the net adjustment exceeds $20 million or 20 percent of gross receipts.¹¹

Documentation That Actually Protects You

The single strongest defense against every risk above is contemporaneous documentation. For transfer pricing between related businesses, that means a formal study prepared before the return is filed, analyzing each entity’s functions, risks, and assets and explaining why the chosen pricing method produces an arm’s-length result. The study does not need to prove the price was perfect; it needs to show a reasonable effort was made.

For non-cash property transferred between family members, a qualified independent appraisal is the essential document. The appraiser should hold a recognized professional designation and have demonstrated competence in valuing the type of property involved, and the appraisal should be completed close to the transfer date and attached to the relevant return.

Loans between related parties need written agreements specifying the loan amount, interest rate, repayment schedule, and maturity date. If the rate is at or above the AFR, the agreement carries most of the weight. If the rate is below the AFR, both parties need to understand the imputed interest consequences and report them consistently.

Buy-sell agreements among family business owners should be supported by a current business valuation from an independent firm, updated periodically and after significant business changes. A five-year-old valuation will not convince the IRS that today’s agreement price is comparable to what unrelated parties would negotiate.

All of this documentation supports a reasonable-cause-and-good-faith defense. Even when the IRS ultimately adjusts a valuation, a well-prepared study or appraisal in the file before the return was filed can eliminate the accuracy-related penalty. The penalties are designed to punish carelessness, not honest disagreements about value backed by credible analysis.

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 1239 – Gain From Sale of Depreciable Property Between Certain Related Taxpayers
3
Office of the Law Revision Counsel. 26 USC 2512 – Valuation of Gifts
4
Internal Revenue Service. What’s New – Estate and Gift Tax
5
Internal Revenue Service. Gifts and Inheritances
6
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
7
Internal Revenue Service. Applicable Federal Rates Rulings
8
Office of the Law Revision Counsel. 26 USC 482 – Allocation of Income and Deductions Among Taxpayers
9
Office of the Law Revision Counsel. 26 USC 2703 – Certain Rights and Restrictions Disregarded
10
Office of the Law Revision Counsel. 26 USC 6038A – Information With Respect to Certain Foreign-Owned Corporations
11
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments