New IRS Campaign Brings Increased Scrutiny to Related Party Transactions

In January, the IRS announced a rollout of its compliance campaigns targeting certain issues on which the IRS Large Business & International (LB&I) will focus its examinations. It is part of LB&I’s shift to issue-focused examinations in light of a diminished IRS budget. Since the announcement, LB&I has been conducting a series of webinars on its 13 new campaigns.  On June 6, LB&I executives provided information on its Related-Party Transactions (RPT) campaign, which is one of the 13 campaigns.

The IRS selected Related-Party Transactions (RPT) as a compliance campaign to help determine levels of compliance in transactions among commonly held/controlled entities in the mid-market segment (taxpayers having access to under $10 million).  Of particular interest to the IRS are transactions between commonly controlled entities that allow taxpayers to transfer funds from a corporation to related pass-through entities or shareholders. The IRS has not, however, announced that there are any particular related-party transactions it will focus on in the audits.

Even prior to announcing this campaign, we have seen the IRS disfavor related party transactions.  For example, the IRS has taken the position that related party loans are not eligible for a discount if the justification for one is based on aspects of the loan as a result of the related-party nature of it, such as a lack of security.  We have also seen the IRS challenge sales of property between related land investment and development entities in order to deny capital gain treatment to the investment entity on the sale of the property to the development entity, instead treating it as ordinary income subject to a much higher rate.  Similarly, the IRS has looked carefully at whether a transaction between related parties qualifies for installment sale treatment. In addition, we envision there may be many transactions with related party foreign entities that will also generate scrutiny.

Audits are already underway for RPTs under this campaign, and more can be expected. Mid-market taxpayers filing corporate returns reporting any related party transactions could be subject to increased audit risk with this new campaign. Even if taxpayers do not fall within the ambit of the RPT compliance campaign, taxpayers and tax professionals should take care to track the LB&I compliance campaigns because there are twelve other existing compliance campaigns and these are just the beginning.