A non-arm’s length transaction is any deal between parties whose existing relationship could influence the price or terms, such as a sale between family members, between a shareholder and their corporation, or between a parent company and its subsidiary. Because that relationship removes the ordinary push and pull that produces a market price, the IRS treats these deals with automatic suspicion. When the price strays from fair market value, the agency can rewrite the economics of the transaction, impute income or gifts that never actually changed hands, disallow losses, and impose accuracy penalties of 20% or 40% on the resulting underpayment.
The Standard the IRS Measures You Against
The benchmark is the arm’s length standard. Two strangers negotiating a used car act at arm’s length: each pushes for the best deal, and the price they reach reflects what the car is actually worth. That competitive tension produces fair market value, defined as the price a willing buyer and willing seller, neither forced to act and both reasonably informed, would agree on.
Take that tension away and the price loses its credibility. A pre-existing relationship doesn’t prove the parties manipulated anything, but it shifts the burden. You have to be able to show that the number on your contract is what an unrelated buyer would have paid.
Who the IRS Treats as a Related Party
Section 267 of the Internal Revenue Code lists 13 categories of related persons. Falling into any one of them puts your transaction under heightened scrutiny.
Family Members
For tax purposes, “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 definition does not include aunts, uncles, cousins, or in-laws on its own, though constructive ownership rules can pull them in indirectly.
Constructive ownership is where the net widens. Under Section 267(c), you’re treated as owning any stock your family members own. If your daughter owns 60% of a company, the IRS treats you as owning that stock too, and any deal between you and the company is a related-party transaction. Attribution also flows through partnerships, estates, and trusts, with stock treated as owned proportionately by partners, beneficiaries, or shareholders.
Businesses and Entities
Corporate relationships get the same treatment. A parent and its subsidiary 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 transactions 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, between a corporation and a partnership with more than 50% overlapping ownership, and between an estate’s executor and a beneficiary. The existence of the relationship is enough. The IRS does not have to prove the parties conspired to manipulate anything.
What the IRS Can Do to the Deal
When the agency identifies a related-party transaction priced away from fair market value, it can rewrite the economics. Sell stock worth $100,000 to your child for $10,000 and the IRS treats the deal as a $100,000 sale plus a $90,000 gift. Both parties then face tax consequences on amounts that never moved in cash.
This 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 doing so is necessary to prevent tax evasion or to clearly reflect income. The statute is deliberately broad. It reaches incorporated and unincorporated businesses, domestic and foreign entities, and affiliated and unaffiliated groups.
Section 267 adds a separate rule that hurts even more directly: it flatly prohibits deducting losses on sales between related parties. You cannot sell depreciated stock to your brother, claim the loss, and let him keep the stock at a lower basis. The loss simply vanishes for tax purposes.
The Penalties If the Price Is Wrong
The accuracy-related penalty under IRC Section 6662 imposes a 20% penalty on underpayments attributable to a substantial valuation misstatement, doubling to 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. A gross misstatement kicks in 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. A gross misstatement applies at 400% or more (or 25% or less). Alternatively, a substantial misstatement exists when the net Section 482 adjustment exceeds the lesser of $5 million or 10% of gross receipts, with the gross misstatement threshold at $20 million or 20% of gross receipts.
The penalty only applies 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 disclose your way out: the Form 8275 disclosure safe harbor does not cover misstatements attributable to non-arm’s length prices.
Selling Real Estate to a Family Member
The most common scenario people run into is selling a home or investment property to a relative below market value. Sell a property with a $500,000 fair market value to your child for $100,000 and the IRS treats the $400,000 difference as a taxable gift that must be reported on Form 709.
Reporting is not the same as paying. Each person can give up to $19,000 per recipient in 2026 without filing a gift tax return at all. Beyond that annual exclusion, each person has a $15 million lifetime gift and estate tax exemption for 2026, meaning cumulative taxable gifts and estate transfers up to that amount pass without any gift tax actually being due. You still have to file Form 709 to report gifts above the annual exclusion, but filing doesn’t mean writing a check.
The loss side is stricter. Section 267 prevents you from selling property to a sibling below your purchase price and deducting the loss. The rule exists specifically to shut down manufactured losses between people in your orbit.
One boundary worth flagging on the lending side: FHA loans treat sales between related parties as “identity-of-interest transactions” and cap the loan-to-value ratio at 85% instead of the standard 96.5%. On a $300,000 purchase, that means $45,000 down instead of $10,500. Limited exceptions exist for buying a family member’s primary residence, for tenants who have rented the property for at least six months, for employees buying from a builder-employer, and for corporate relocations.
Lending Money to Family or Shareholders
A zero-interest loan to a relative or shareholder looks harmless. The IRS treats it as two transactions: a loan at the market rate plus a gift of the interest the lender should have charged. IRC Section 7872 governs this territory.
The market rate for this purpose is the Applicable Federal Rate, published monthly by the IRS as a revenue ruling. AFRs come in three tiers: short-term for loans of three years or less, mid-term for loans over three years up to nine, and long-term for loans over nine years. If your stated rate falls below the AFR, the IRS imputes the shortfall as interest income to the lender and, in a gift loan, as a gift from lender to borrower.
Two thresholds soften the rule for smaller loans:
- A $10,000 de minimis exception. If the total outstanding balance between two individuals stays at or below $10,000, the imputed interest rules don’t apply. The same threshold applies to compensation-related and corporate-shareholder loans.
- A $100,000 investment income cap. 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 net investment income is $1,000 or less, it’s treated as zero. This exception disappears if a principal purpose of the loan is tax avoidance.
Both exceptions vanish once the aggregate balance exceeds $100,000, at which point the full AFR applies to the entire balance. For business-context loans, the lender must file Form 1099-INT for interest of $10 or more, or $600 or more for certain business-related interest payments.
A written promissory note with a repayment schedule and an interest rate at or above the AFR is the single most effective protection. Without that paper, the IRS can reclassify the “loan” as a gift or, in the corporate context, as a constructive dividend.
Paying a Related Person for Services
When a closely held business pays a shareholder or family member more than the market rate for their work, the IRS can recharacterize the excess. A shareholder who receives compensation above what a third party would accept for the same work may have the excess treated as a constructive dividend.
The distinction matters. Salary is deductible by the corporation and subject to employment taxes. A constructive dividend is not deductible, so the company loses the deduction while the shareholder still owes tax on the income. The same logic applies to inflated management fees charged by a related holding company. If the fee exceeds what an independent firm would charge, the excess gets recharacterized.
The IRS weighs reasonableness against factors including 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. Companies that pay generous salaries but never declare dividends draw extra scrutiny, because the pattern suggests the salary is a disguised distribution.
Documentation You Need Before the Deal Closes
In any related-party transaction, the burden of proof sits with the taxpayer. Documentation has to exist before the deal, not after an audit letter arrives.
For real estate and other asset transfers, get an independent appraisal from a certified appraiser. The appraisal 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, the minimum is a written promissory note stating the loan amount, an interest rate at or above the AFR, a repayment schedule, and signatures. Treat it the way a bank would. Payments should move through traceable accounts, and the lender should report interest income.
For corporate transfer pricing, Treasury regulations under Section 482 require contemporaneous documentation identifying the pricing method used, explaining why it was the most reliable, and providing the supporting data and analysis. If the IRS requests this documentation, you have 30 days to produce it. Producing it on time is a prerequisite for avoiding the enhanced penalties under Section 6662(e). Companies without documentation face penalties starting at 20% with no disclosure escape.
Reporting for Foreign-Owned Entities
Any U.S. corporation that is at least 25% foreign-owned must file Form 5472 to report related-party transactions during the tax year. The requirement also reaches foreign-owned U.S. disregarded entities, which file a pro forma Form 1120 with Form 5472 attached. The obligation sits under Sections 6038A and 6038C, and penalties for non-compliance are steep.