It is common for owners of construction companies to have ownership interests in multiple and varying types of business entities. There are numerous advantages to be had when commonly owned entities work with one another, however, conducting business with related parties also creates exposure to potential tax liabilities and raises red flags for the IRS to investigate the potential occurrence of non-compliance with applicable statues. Three transaction types that are commonly conducted amongst related parties, and also a primary focus of IRS investigations, are loans to and from owners, compensation paid to owners, and rental payments to commonly owned entities.
- Loans to and from owners – The IRS requires that interest be imputed for all outstanding loan balances to and from owners greater than $10,000 that does not provide a reasonable interest rate. Interest is to be computed annually on the amount outstanding as of December 31st. Keep in mind that any notes receivable from an owner is interest income to the company and a distribution to the owner. Conversely, any notes payable to an owner is interest income to the owner and interest expense to the company. The IRS will take many elements into consideration during an investigation to identify intent of the note. IRS interest rate requirements and IRS speculation can be avoided and/or minimized by executing a written promissory note with a reasonable rate of interest and a due date.
- Compensation of Owners – Compensation (salaries, bonuses, and fringe benefits) to owners must be reasonable in amount and solely for services rendered. When services are provided to multiple entities, the IRS can consider total compensation from all related parties. It is important for the company to document a clear job description, and a defined role within each entity for the owner. Depending on the entity structure of the company, different issues are more likely to be scrutinized. When dealing with C Corporations, the IRS will focus an investigation into whether compensation is reasonable, and clearly defined so it is not ruled as a dividend. In the case of pass through entities, the IRS is more concerned with the issue of under compensation. When an owner is undercompensated, it creates the opportunity for the owner to attempt to avoid payroll taxes or transfer income to nonemployee owners that can be family members at a lower tax bracket. The IRS is considering a proposal that would make all earnings of an S Corporation subject to Self-Employment tax similar to the current tax treatment for LLCs. There has been an increase in cases involving under compensation as the IRS is being aggressive conducting investigations.
- Rental Payments – Owners commonly rent land, buildings, and equipment to their businesses from other entities they have ownership in. Payment of rent to a related party raises multiple issues, including reasonableness. If the expense is too high, a constructive dividend might result. In pass-through entities, high rent may be an attempt to avoid Self-Employment Tax, and low rent may signal a gift has been made. Any lease agreements with related parties should have a signed lease agreement in place containing customary commercial lease terms and regular payment of fair market rent. Equipment leases should be structured as close to industry practice as possible.
These are just a few of the more commonly found areas in which the IRS will conduct investigation into related party transactions. Any of these issues can become complicated quickly, so review your construction company’s procedures so that non-compliance is not an issue. For additional inquiries, contact Aronson LLC to help review your construction company’s current practices, or to assist in developing solutions to a related party issue.