Related-Party Transaction
A related-party transaction is a purchase, sale, lease, or loan between a business and a party connected to its owner, such as an owner-controlled real estate entity, a family member on payroll, or an affiliated company charging management fees, with terms set by the relationship rather than by an arm's-length market. Related-party transactions are repriced to market when recasting earnings, which can raise or lower normalized earnings depending on which side of market the current pricing sits.
Also called Affiliate Transaction, Non-Arm's-Length Transaction, Insider Transaction · Last updated 2026-08-07 · All 24 terms
Where related parties hide on a small-business P&L
Related-party arrangements rarely announce themselves. On a tax-basis P&L they look like ordinary expense lines, and the reliable way to find them is to ask who sits on the other side of each significant vendor and payroll relationship.
Reviewed and audited financial statements do carry a disclosure, since ASC 850 requires related-party transactions and balances to be disclosed. Most Main Street sellers have no reviewed statements, so the disclosure has to be reconstructed from the returns and a conversation with the owner. Loans to and from shareholders appear on Schedule L of the corporate return. Rent paid on a building the owner holds personally shows up as rental income on that owner's Schedule E, or on Form 8825 when the real estate sits inside another partnership or S corporation.
- Rent or lease payments to a realty entity the seller owns
- Wages, benefits, or a company vehicle for a spouse, child, or parent
- Management, consulting, or administrative fees paid to an affiliated company
- Inventory, materials, or services bought from or sold to another business the owner controls
- Shareholder loans, and the interest expense or interest income they generate
- Employees shared across two of the owner's companies with no cost allocation between them
- Equipment titled to the owner personally and used by the business rent-free
Normalizing rent, in both directions
Owner-occupied real estate is the most common related-party item in the lower middle market, and it moves earnings in whichever direction the owner set rent for tax reasons.
In this example the business occupies a 6,000 square foot flex building, and assume comparable space in the submarket leases at $13.00 per square foot per year on a triple-net basis. Market rent is then $78,000 per year, or $6,500 per month. That rate is an assumption inside the example, not a market benchmark.
Case one, below market. The company pays its owner's realty LLC $3,000 per month, $36,000 a year, because the owner preferred distributions to rental income. A buyer will pay market, so normalized earnings drop by $42,000, the difference between $78,000 of market rent and the $36,000 reported. Sellers are consistently surprised by this direction.
Case two, above market. The company pays $12,000 per month, $144,000 a year, because the owner used rent to move cash out of the operating entity. Normalized earnings rise by $66,000, the excess over $78,000. That one is a legitimate add-back and it requires exactly the same market-rent evidence as case one.
The multiple is what makes it matter. At an illustrative 3.5x, the $42,000 downward adjustment in case one is $147,000 of value, enough to break a deal priced before anyone read the lease.
The lease is a deal term, not just an adjustment
Normalizing the rent figure settles the arithmetic. It does not settle the transaction, because after closing the buyer becomes a tenant of the seller and the lease has to exist as a signed document at the normalized rate.
Lease terms that get agreed in the letter of intent rather than discovered in diligence cause the fewest problems later. A seller hoping to keep above-market rent as a retirement annuity generally learns early that an acquisition lender will size the deal off market rent regardless of what the lease says.
Market evidence carries the whole argument. A one-page opinion of market rent from a commercial broker, or two or three comparable lease listings with dates and rates attached, converts a contested adjustment into an accepted one. The terms buyers and their lenders read most closely:
- The rate, and whether it matches the rate used in the recast
- The term and any renewal options, which acquisition lenders commonly want to see extend across the life of the loan
- Assignability, which lenders frequently ask for so the lease can pass to them or to a subsequent operator
- Who pays taxes, insurance, and maintenance, which decides whether a triple-net comparable is comparable at all
- What happens if the seller later sells the building to a third party
Related-party is not the same as discretionary
The distinction is easy to state and frequently missed. A discretionary expense is one the buyer does not have to incur at all. A related-party expense is usually one the buyer does have to incur, at a different price.
The business genuinely needs the building. What is wrong is the rate, not the existence of the cost. So a related-party item gets repriced to market rather than added back to zero, and treating it as a full add-back is among the fastest ways to lose credibility with a buyer's accountant.
Family payroll follows the same logic and runs both ways. A relative drawing $45,000 for a role they do not perform is genuinely discretionary and comes back in full. A relative doing real work for $20,000 in a role that would cost $55,000 to replace requires imputing $35,000 of additional expense, which reduces normalized earnings. Both patterns turn up inside the same company more often than one would expect.