The holidays are a time for families to gather, eat, and share memories. And, it seems, to scheme to reduce taxes. At least that seems to be what the tax code assumes, with its rules restricting deductions for payments to relatives.
Yes, you can usually deduct payments to relatives...but only in the year the relatives include them in income.
Accrual-method taxpayers can deduct payments owed to unrelated employees if they are made within 2 1/2 months of year-end. Many non-wage payments to unrelated taxpayers accrued at year-end can be deducted if paid as long as 8 1/2 months after year end.
But Code Section 267 only allows a deduction to a related party "as of the day as of which such amount is includible in the gross income of the person to whom the payment is made." That's no problem if the "related party" is on the accrual method, because they will be accruing the income at the same time you accrue the expense. But if the related party is a cash-basis taxpayer, you have to pay up to get that deduction.
Who is "related?" It's a wide net. Most problems arise with closely-held accrual-method businesses and their cash basis owners. If you have a C corporation, only owners of more than 50% of the stock, and their families (siblings, spouses, ancestors and descendants) are related. For pass-through entities -- partnerships and S corporations -- any owner is a related party, along with members of owners families and anybody related to the family members. Commonly-owned businesses are also considered related.
The broad definition of related parties for pass-throughs means that if a calendar year accrual-method S corporation accrues a bonus for a 2011 shareholder's nephew payable in January 2012, the deduction gets deferred until 2012. The same thing applies to interest expense, rental expense, or any other expense owed to a cash-basis related party.
So enjoy the holiday turkeys, roasts, hams and bowl games. Just make sure you take the time to cut the checks to any relatives to whom you owe deductible expenses, if you want that deduction this year. Check with your tax pro to make sure you get it right.