Recently, I’ve come across various instances of related party transactions with several of my clients, such as stockholder notes to or from the company, a stockholder leasing office space to a company at favorable rates, forgiveness of compensation or reduced compensation for the initial startup period, and favorable credit terms to another entity with common ownership to name a few examples. And it worries me sometimes when companies enter into these transactions without thinking through the accounting ramifications, which can be problematic.
What could the risks of related party transactions be?
For instance, a company could be subject to variable interest entities (VIE) rules triggering a requirement to consolidate with the related entity (see my post, Step by Step Approach to the VIE Conundrum, to understand how to avoid this trap). Not only are such consolidations of financials more cumbersome, but they could also result in a lower margins if the related entity is not quite so profitable. Not such a good idea when you likely have bank covenants to comply with.
The other potential risks include liability issues if relations between your company and the related entity become strained and disallowance of certain expenses by the IRS if not considered as an arm’s-length transaction.
So, here are 4 steps to help you to reduce your risk of non-compliance where related party transactions are concerned:
- Document (yes, as an auditor that is one of my favorite words!) key aspects of the related party transactions – name of the party/parties involved, scope of the arrangement, key terms such as interest rates, repayment period etc. as well as the intended period of the arrangement.
- Ensure that the transaction has a valid business purpose to avoid unwanted scrutiny from the taxman.
- Understand the nature of the transaction and make adequate and appropriate disclosures in the financials of related party transactions.
- Most importantly, speak to your trusted advisors if you are uncertain of the accounting and tax implications of a related party transaction before the transaction to avoid costly mistakes in the future.