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Year-end deductions: beware related parties

December 30, 2009

As the tax year winds up, businesses are busy accruing year-end expenses to get the deduction into this year. They need to be careful: if you owe money to a cash-basis "related party," it's not enough to accrue the expense this year. You need to pay it to deduct it.

Code Section 267 only allows a deduction to a related party "as of the day as of which such amount is includible in the gross income of the person to whom the payment is made." That's no problem if the "related party" is on the accrual method, because they will be accruing the income at the same time you accrue the expense. But if the related party is a cash-basis taxpayer, you have to pay.

Who is "related?" It's a pretty wide net, but most problems arise with closely-held accrual-method businesses and their cash basis owners. If you have a C corporation, only owners of more than 50% of the stock, and their families (siblings, spouses, ancestors and descendants) are related. For pass-through entities -- partnerships and S corporations -- any owner is a related party, along with members of owners families and anybody related to the family members.

The broad definition of related parties for pass-throughs means that if a calendar year accrual-method S corporation accrues a bonus for a 2009 shareholder's nephew payable in January 2010, the deduction gets deferred until 2010. The same thing applies to interest expense, rental expense, or any other expense owed to a cash-basis related party.

The year is almost over. Time to review the Tax Update's 2009 year-end planning tips!