Matching Between Related Parties

[JohnH]

The general rule for related party transactions is that an accrual basis taxpayer cannot deduct an expense incurred for payments to an accrual-basis related party unless paid within 2-1/2 months of the year-end. Correct? But now I have a reverse situation which has me talking to myself.

Entity A is an S-Corp, reporting on an accrual basis, with one 100% shareholder. Entity B is an S-Corp, reporting on the cash basis, in which the sole shareholder in Entity A owns 28% and his wife owns 28%. So there's a controlled group involved here.

Entity B incurred significant expenses in 2016 for administrative services provided by Entity A, which are still unpaid. It appears that in this case Entity A (accrual basis) must report the income while Entity B (cash basis) cannot take a deduction, so the cash-basis reporting for Entity B is causing a mismatch and over-reporting of income for Entity A in 2016, which of course flows through to the personal tax returns of the 100% shareholder. Eventually the situation will right itself, but it's a sticky matter for 2016 unless there is a rationale for matching the revenue recognition and the eventual payment.

I'm probably grabbing at straws, but is there any logical basis or matching principle for Entity A to exclude the income until Entity B pays up?

[Snaggletooth]

No Deduction for B

John, I believe this is a casualty of related party rules. Corporation A and Corporation B are related taxpayers, having more than 50% common ownership. The non-payment results in income for one and no deduction for the other.

This probably is unexpected by the owners and not likely to be popular. Make sure if you are preparing taxes in the succeeding year that you compensate for the 2016 situation if and when all parties pay up. Many times in a situation like this a cash-strapped company will avoid paying whomever they can, and the most likely not to be paid are common owners. Such an arrangement is devastating to their tax situation, and this should have been planned for in advance.

I'll bet it wasn't.