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:: Farmers Audit Techniques Guide - Chapter Two - Related
Entities
Related
Entities
Introduction
Farming usually
starts as a family
business. There will be uncles,
brothers, sisters, children,
etc. either involved with the
farm or having a farm of their
own. Transactions for farms
between related persons and
related entities are therefore
common and the issues raised are
addressed in certain code
sections and court cases.
Sometimes the
reasons for related entities to
exist are due to regulatory
agencies. In the past, the drier
regions saw a large increase in
the number of farm partnerships
due to federal water
restrictions. Some of the more
common farm entities and reasons
for existing are listed below:
-
Incorporated to limit
liability exposure.
-
Partnerships to gain
help or land to farm.
-
Controlled groups of
different entities to
farm different lands
and/or increase buying
power.
-
Sole
proprietorships for the
home farm.
Audit
Issues and Techniques
The reasons for
having more that a single entity
are numerous. Several tax issues
can occur. Income can be
affected by delaying the payment
until after a year-end,
non-payment, use of
non-arms-length transactions,
such as no/low interest loans,
services, rentals and sales of
entities with related parties.
A flowchart of
all the related entities with
their ownership percentages and
major transactions will help
throughout audits with related
parties. The term “related” can
have many interpretations to
taxpayers and representatives.
In Example B (below), the
management entity in the actual
case was owned by a sole
shareholder unrelated to the
taxpayer(s). The auditor pursued
this anomaly and found the
shareholder had no day-to-day
control over the operations of
the company nor did he have
signature authority over any of
the bank accounts. Substance
versus form says this is a
related entity. Another example
was a corporation owned
one-sixth by one taxpayer, which
was not listed as related. It
was found to be operated by the
taxpayer’s staff and handled all
the almond income of the
taxpayer. Timing issues were
found (see Example A).
Related
entities can also be packing
houses, brokers, storage plants,
insurance companies, etc. After
determining the related parties,
you should update and review the
related entities flowchart to
determine the constructive
ownership percentages by
applying the rules of
attribution per IRC § 267. If
there is a large corporation and
gross income is near
$25,000,000, then check IRC §
447 to determine if it should be
using the accrual method of
reporting income. Sometimes an
agent would start an audit of a
simple tax return and have that
lead to opening audits of larger
related entities.
Examples of tax issues
-
Related
entity sells the crop of a
taxpayer, but does not pay
the proceeds due until after
the year-end of the
taxpayer, with no deferred
payment contract. IRC §§ 61
and 461 govern this issue.
-
Similar to
A, a management entity sells
the crop of taxpayer(s) and
there is a deferred payment
contract that moves payment
to the following year. The
management entity loans the
taxpayer(s) prior to the
year-end money that is
repaid the following year by
“netting” crop proceeds
against the outstanding loan
amounts. Notes were executed
and interest is paid. This
is a substance versus form
case in which several
factors must be considered.
-
Was the
management entity
formed/financed by the
taxpayer receiving the
benefit?
-
Were
the liabilities for any
loans and payments
legally those of an
unrelated third party?
-
Was
there some business or
regulatory reason to
structure the
transaction in this
manner?
-
Whose
capital is invested in
the transaction?
-
How
many non-related parties
are there in the
transaction?
-
Rental
expense per contract is not
paid to the related
taxpayer. This is an IRC §
482 issue that must be
developed by cash usage
analysis and proof that a
tax benefit was obtained.
-
Farming
services are performed by a
related entity but are
allocated in a manner to
create tax benefits rather
than based on relevant
facts. This is an IRC § 482
issue that requires learning
the allocation method and
analyzing the tax returns of
the related entities for the
amount of tax benefits
obtained.
-
Similar to
D above, almond income was
received by a related entity
and allocated to entities
differently from their crop
percentages. The entities
reporting the sales had
losses being carried forward
and the entities not
reporting the sales had
taxable income. This was a
manipulation for tax
benefits (IRC § 61 or 482).
-
Income can
also be reclassified to be
passive in order to offset
suspended passive
losses. The spread analysis,
comparing several years of
tax returns, could show this
(IRC § 469).
-
Unharvested
crop costs can be sold to a
related entity to transfer a
loss, where the selling
entity already is carrying
forward unused losses (IRC §
267).
Pertinent Code Sections
IRC § 267 does
not allow the deduction of
losses on sales or exchanges
between related persons, but
does not apply to a complete
liquidation. It also addresses
the matching of payee income and
payor deduction in cases where
the methods of accounting are
different. This means an accrual
basis taxpayer cannot deduct
expenses to a related person or
related entity that is cash
basis until the accrued expense
is paid unless the recipient,
under their method of
accounting, reports the
receivable as taxable income.
IRC § 267(b)
defines who related taxpayers
are and IRC § 267(c) defines the
constructive ownership of stock.
IRC § 482
authorizes the allocation of
income, deductions, credits or
allowances in order to clearly
reflect the income on
transactions between related
entities. It is commonly used by
the international auditors on
transfer pricing issues between
foreign corporations and their
U.S. subsidiaries. The purpose
of IRC § 482 is to ensure that
taxpayers clearly reflect income
attributable to controlled
transactions, and to prevent the
avoidance of taxes with such
transactions. It is meant to
place a controlled taxpayer on a
tax parity with an uncontrolled
taxpayer by determining the true
taxable income of the controlled
taxpayer in a manner that
reasonably reflects the relative
economic activity undertaken by
each taxpayer.
Treas. Reg. §
1.482-2 provides rules for the
determination of the true
taxable income of controlled
taxpayers in specific
situations, including controlled
transactions involving loans or
advances, services and
property. The standard used to
determine the true taxable
income of a controlled taxpayer
is that of a taxpayer dealing at
arm’s length with an
uncontrolled taxpayer. The
definition of the terms
“controlled taxpayer,” etc. are
at Treas. Reg. § 1.482-1(i)(5).
Sometimes the
taxpayers or return preparers
say that the original
transactions were erroneously
recorded. If this is given as
an audit issue position, review
Utley v. Commissioner, 906 F.2d
1033 (5th Cir. 1990). It did not
allow the taxpayers to
recharacterize a transaction
contended to be an accounting
error.
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