Recognizing when the IRS can reallocate income.

• Author: Bland, Larry N., Jr.

Transactions between related parties come under close scrutiny by the IRS because they are not always conducted at arm's length. If the amounts involved in the transaction do not represent fair market values, the IRS can change the characteristics of the transaction to reflect its actual nature.

The IRS may attempt to reallocate income between a closely held corporation and its shareholders based on several sets of rules, including the following:

* Assignment-of-income rules that have been developed through the courts;

* The allocation-of-income theory of Sec. 482; and

* The rules for allocation of income between a personal service corporation and its employee-owners of Sec. 269A.

Assigning income to the entity that earns or controls the income

Income reallocation under the assignment-of-income doctrine is dependent on determining who earns or controls the income. Justice Oliver Wendell Holmes made the classic statement of the assignment-of-income doctrine when he stated that the Supreme Court would not recognize for income tax purposes an "arrangement by which the fruits are attributed to a different tree from that on which they grew" (Lucas v. Earl, 281 U.S. 111, 115 (1930)).

Reallocating income to prevent tax evasion

Reallocation under Sec. 482 is used to prevent tax evasion or to more clearly reflect income when two or more entities are controlled by the same interests. Note the use of the word "or" in the preceding sentence. The Code empowers the IRS to allocate income even if tax evasion is not present if the allocation will more clearly reflect the income of the controlled interests. The intent of these provisions is to place the controlled entity in the same position as if it were not controlled so that the income of the controlled entity is clearly reflected (Regs. Sec. 1.482-1(a)).

Example 1. Performing services for another group member: Corporations P and S are members of the same controlled group. S asks P to have its financial staff perform an analysis to determine S's borrowing needs. P does not charge S for this service. Under Sec. 482, the IRS could adjust each corporation's taxable income to reflect an arm's-length charge by P for the services it provided to S.

Reallocating between a personal service corporation and its employee-owners

Under Sec. 269A(a), the IRS has the authority to allocate income, deductions, credits, exclusions, and other items between a personal service corporation (PSC) and its employee-owners if:

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