Are related-party transactions a red flag when buying a business?

A related-party transaction is a dealing between the business and the owner, a relative or a company they control. Rent paid to the owner’s holding company, a spouse on payroll or a supplier owned by the family are examples. None is wrong in itself. The concern is that the price or terms may not be what an outsider would have agreed to.

What it does to the numbers

If rent, wages or supplier prices are set by the owner, the earnings in the financial statements reflect those choices. Ask for each related-party arrangement in writing, and ask whether the buyer would pay the same under a normal contract. Then see which arrangements end at closing and which carry on.

How tax law treats them

Under section 69(1) of the Income Tax Act, except as expressly otherwise provided in the Act, a taxpayer who acquires property from a person not dealing at arm’s length for more than fair market value is deemed to have acquired it at fair market value. A taxpayer who disposes of property to such a person for no proceeds or for less than fair market value is deemed to have received proceeds equal to fair market value. Section 15(1) includes in a shareholder’s income a benefit conferred on the shareholder by the corporation, subject to the exceptions listed there.

Insolvency and corporate law

Under section 96 of the Bankruptcy and Insolvency Act, a court may, on the trustee’s application, act on a transfer at undervalue to a party not at arm’s length made in the period from one year before the date of the initial bankruptcy event to the date of the bankruptcy, without proof of insolvency or intent. Under section 4(5), related persons are deemed not to deal at arm’s length while so related; for s. 96(1)(b), that holds in the absence of evidence to the contrary. Section 120 of the Canada Business Corporations Act requires a director or officer, in the circumstances it lists, to disclose in writing or by requesting an entry in the minutes the nature and extent of an interest in a material contract or transaction with the corporation, and under s. 120(8) a court may, on application of the corporation or a shareholder, set aside the transaction or require an account of any profit where the section was not complied with. Provincial corporate statutes have their own versions.

• List every contract and payment between the business and the owner or family.
• Ask which will continue after closing and on what terms.
• Ask the seller’s accountant how each was recorded for tax.

The deal red flags checklist covers other warning signs.