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Unformatted text preview: InterestlncomefiExpense — Below-Market Loans
May Have Unexpected Tax Results Tax advisers should be
aware of the type of
arrangements subiect to
imputed interest rules
under Sec. 7872. This
article describes the
maior types of below-
market loan transactions,
as well as the exceptions
and how the rules apply
to such transactions. 350 THE TAX ADVISER / JUNE 2006 Sec. 7872 recharacterizes a “below—mar—
ket” loan as an arms—length transaction in
which the lender makes a loan to the bor—
rower in exchange for a note requiring
the payment of interest at a statutory rate.
This article discusses the major types of
below—market loan transactions and
exceptions, and illustrates how the rules
apply to such transactions. Background Value is transferred to a borrower when a
loan is made that does not require pay—
ment of interest, or requires interest at a
below—market rate.The tax law recognizes
such transfers of value. In 1984, the U.S.
Supreme Court ruled1 that an interest—
free loan by parents to their son was a
“transfer of property by gift.”The Court
reasoned that a parent who grants rent—
free and indefinite use of commercial
property to a child “has clearly transferer
a valuable property right.The transfer of
$100,000 in cash, interest—free,. . .is simi—
larly a grant of the use of valuable proper—
ty..,.The value of the use of money is
found in what it can produce; the measure of that value is interest—‘rent’ for the use of the funds.”
Later in 1984, Congress added Sec. 1 Esther Ditkman, 465 US 330 (1984). 2JCT, General Explanation aft/7e Revenue Provisions of Howard Godfrey, Ph.D., CPA Professor ofAttourLting
Department ofAccounting
University of North Carolina—Charlotte
Charlotte, NC Robert Guinn, Ph.D., CPA
Associate Professor of Accounting
Department ofAccounting University of North Carolina—Charlotte
Charlotte, NC Edward Malmgren, Ph.D., CPA Associate Professor of Accounting
Department ofAccounting
University of North Carolina—Charlotte
Charlotte, NC 7872 to the Code, which provides detailed
rules regarding the gift and income tax
treatment for various below—market loans,
The joint Committee on Taxation (JCT)
report states that a below—market loan is
the equivalent of a loan bearing a market
rate of interest, accompanied by (1) an
“extra payment” from the lender to the
borrower and (2) a return of that “extra
payment” back to the lender as a payment
of interest on the loan.2 Sec. 7872 requires
the lender to report interest income for an
imputed “extra payment” from the bor—
rower, even though the borrower makes
no interest payment or pays interest at less
than the market rate. In addition, the
imputed “extra payment” may create
compensation or dividend income to the
borrower, depending on the relationship
of the parties. Below-Market loans Sec. 7872(e)(1) defines a “below—market”
loan as a loan that does not require inter—
est payments, or requires such payments at
a rate below a statutorily defined rate.
Congress intended that “loan” be inter—
preted broadly to include extension of
credit. Any transfer of money that pro—
vides the transferor with a right to repay— the Deficit Reduction Act of 1984, 98th Cong, 2d
5638. (12/31/84), p. 527. ment is a loan.3 For example, advances
and deposits may be treated as loans. Demand or Term Loan A below—market loan fits into one of
two categories: demand loan or term
loan, Sec. 7872(f)(5) defines a demand
loan as one payable in full at any time
on demand of the lender. It may also
include a loan with an indefinite matu—
rity. Under Sec. 7872(f)(6), a term loan
is any loan that is not a demand loan.
Under Sec. 7872(a), (b) and (e), interest
is imputed on a demand loan that (1)
requires no interest payment or (2) has
an interest rate below the applicable
Federal rate Interest is imputed
on a term loan when the loan amount
exceeds the present value of the princi— pal and interest payments due under the
loan. Imputed Interest Rate Sec. 7872(e) and (f) require the
amount of imputed interest to be
based on the current market interest
rate as determined by a statutory for—
mula that analyzes interest rates on
Federal obligations of appropriate
maturity. Each month, the IRS pub—
lishes AFRs for short—term, mid—term
and long—term loans. Imputed interest
computations for a demand loan un—
der Sec. 7872(f)(2) are based on the
short—term rate in effect for the period
for which the amount of forgone inter—
est is being determined, For a term loan,
imputed interest computations are
based on the appropriate rate: short—
term (not over three years), mid—term
(over three years, but not over nine
years) and long—term (over nine years) as
of the day on which the loan was made. Sec, 7872(f)(2) requires the use of
semi—annual compounding. For exam—
ple, if the AFR is 10%, a loan that pays
interest at the rate of10% per year is a
below—market loan if it requires annual
compoundingA loan with an interest
rate tied to the prime rate charged by a
major financial institution may be a
below—market loan.According to Prop. 3 Id, at p.529.
4 Id. at p. 530. Regs. Sec. 1.7872—3(e), it is necessary to
test a prime—rate demand loan in each
semi—annual period to determine
whether there is sufficient interest. Below—Market Loon
Transactions Under Sec, 7872(c)(1), transactions
involving imputed interest rules in—
clude: 1.Compensation—related loans be—
tween an employer and an employee or
independent contractor; 2. Loans between a corporation and its
shareholder; 3. Gift loans between relatives or
friends; 4. Loans to a continuing care facility; 5. Tax avoidance loans; and 6. Other arrangements. Common Transactions Employer/employee: Under Sec.
7872(c)(l)(B), a below—market loan by
an employer to an employee for the
performance of services is a compensa—
tion—related loanAn independent con—
tractor may receive a compensation—
related loan from a person to whom the
independent contractor provides ser—
vices. An arrangement is compensa—
tion—related if a compensatory element
arises from the transaction. Certain
transactions could result in multiple
transactions. For example, a below—
market loan by an employer to a child
of an employee may be a compensa—
tion—related loan by the employer to
the employee and a gift loan by the
employee to the child.4 The employer’s receipt of deemed
interest income is offset by a deemed
deduction for compensation expense.
The employee has imputed interest
expense and receives compensation in
exchangeThis imputed compensation
income is included in wages subject to
FICA and Federal Unemployment
Tax5; however, under Sec. 7872(f)(9)
income tax withholding is not required
on this income.An independent con— 51d. I EXECUTIVE SUMMARY 1
I A below-market loan
is broadly defined as a
loan that does not
require interest
payments or requires
such payments at a rate below a statutorily
defined rate. loan rules may apply
to a variety of i J transactions, including I The below-market ( loans between employers
and employees,
corporations and l
shareholders, and
relatives. I For individuals, the
rules do not apply to
small gift loans between
individuals, and, for gift
loans less than $100,000,
imputed interest is limited to the
borrower’s net .
investment income. For more information
about this article, contact
Professor Godfrey at
hgodfrey®ernail.uncc.edu. THE TAX ADViSER / JUNE 2006 351 Interestlncomefi’Expense — tractor is subject to the same rules for
recognition of income, but not the
reporting requirements applicable to
employees. Corporation/shareholder: When
there is a below—market loan by a cor—
poration to its shareholder, the lender
recognizes imputed interest income
and is treated as having transferred that
income back to the shareholder as a
dividend or return of capitalThe bor—
rower (shareholder) is treated as having
received a distribution and then having
paid interest expense to the lender.
When a shareholder makes a below—
market loan to a corporation, the share—
holder has imputed interest income
that is treated as being given back to
the corporation as a contribution to
capital. Gift loans: For below—market
loans between family members or in
other cases of donative intent, the
lender has imputed interest income
and is treated as making a gift to the
borrower. The borrower is treated as
having received a gift and returned
the funds to the lender in the form of
interest expense. Continuing care facility: A continu—
ing care facility may require refiindable
deposits from individuals who become
residents.This type ofloan is covered
by Sec. 7872, but, as explained later,
there is a significant exception. Tax avoidance: Sec. 7872(c)(1)(D)
defines a below—market loan as a tax
avoidance loan when one of the prin—
cipal purposes of the interest arrange—
ment is the avoidance of any Federal
tax by either the borrower or the
lender. Under Sec. 7872(c)(3), the
$10,000 de minimis exception is not
applicable to a tax avoidance loan clas—
sified as a compensation—related or a
corporate—shareholder loan. ' _ Other arrangements: Sometimes,
the classification of the imputed pay—
ments depends on the transaction’s
substance. For example, according to
Prop. Regs. Sec. 1.7872—1(a), an inter—
est—free loan to a charitable organiza— 6 Id.
7 Linda Craven, 215 F3d 1201 (11th Cir. 2000). 352 THE TAX ADVISER / JUNE 2006 tion is a loan on which adequate inter—
est is charged, followed by a charitable
contribution of the imputed interest
from the lender to the charity. If the
loan is made to an entity other than a
shareholder or employee, the imputed
transfer is handled in accordance with
the nature of the relationship. The loan
may give an indirect benefit to an
employee, or it may be a form of addi— For a term loan,
imputed interest is included
as OID. tional compensation for the other enti—
ty. The Committee Reports for Sec.
7872 include an example of an invest—
ment banker being permitted by an
issuer to retain the proceeds from a
public offering of stock or debt for a
period without paying interest.6 This
arrangement is a below—market loan
from the issuer to the banker. To the
extent the benefit is in lieu of a fee for
services, the loan is a compensation—
related loan. Property Purchase Loan When a loan with a below—market
interest rate is used in the purchase of
property, either Sec. 483 or 1274 may
require recognition of original issue
discount (OID).The OID is amortized
(as interest income to the seller and
interest expense to the buyer) over the
life of the loan, as required under Sec. 7872. Sec. 7872(f)(8) provides that Sec.
7872 is not applicable if Sec. 483 or
1274 applies to a loan. Divorce Settlement Loan In a divorce, one party may keep a
major asset, such as the family business,
and agree to pay the other party a sum
of money over time to equalize the divorce settlement.This arrangement
has raised the question of whether a
divorce may result in (1) a sale of prop—
erty with a below—market loan subject
to Sec. 483 or 1274 or (2) a gift loan
subject to Sec. 7872. For example, in Craven,7 the taxpay—
er agreed to accept $4.8 million for
redemption of her stock in a closely
held corporation in a divorce settle—
ment in 1991.The price was to be paid
over a period of years and the note did
not bear interest.The divorce agree—
ment stated that Form 1099-INT
would be issued each year for the
imputed interest on the loan. The IRS
conceded in court that the interest
would not be taxable under Sec. 1274,
if the stock redemption was held non—
taxable under Sec. 1041.The Eleventh
Circuit found that the redemption was
not taxable under Sec. 1041, and
accordingly found there was no imput—
ed interest under Sec. 1274.This treat—
ment was included in proposed regula—
tions for Sec. 1274 issued in 1986, and
was retained in final Regs. Sec. 1.1274—
1(b)(3) (iii) in 1992. Sec. 1041 treats a transfer of proper—
ty in a divorce as a gift; however, that
does not cause a below—market loan
related to a property settlement to be a
gift loan under Sec. 7872. Letter Rul—
ing 86450828 addressed these issues for
a note given to equalize the distribu—
tion of assets in a divorce settlement.
The IRS reasoned that Secs. 483 and
1274 do not apply in matrimonial
transactions because they only apply to
contracts for sale of property, and a
transfer of property in a divorce under
Sec. 1041 is not treated as an exchange.
This rule is now part of the regulations
for Secs. 483 and 1274.The IRS fur—
ther reasoned that the parties negotiat—
ed the settlement without donative
intent, thus preventing the transaction
from involving a gift loan under Sec.
7872.Accordingly, the IRS ruled Sec.
7872 does not apply to a noninterest
bearing note given in a divorce settle—
ment. 8 IRS Letter Ruling 8645082 (8/14/86). Determining and Reporting
lmputed interest
Term Loans With a below—market “term loan”
(other than a gift loan), the “imputed
interest” is computed under Sec.
7872(b) by subtracting (1) the present
value ofall payments required under
the loan from (2) the amount loaned.
The amount loaned is the amount paid
to the borrower.The imputed interest
is treated as OID.The lender is treated
as having transferred the OID amount
to the borrower when the loan was
made, and the borrower is treated as
having received that amount on the
same dayThe present value is comput—
ed using the AFR in effect on the loan
date. Sec. 1272 requires the lender to rec—
ognize a portion of the OID as interest
income each period. Sec. 163(6)
requires the borrower to compute
interest expense in a similar manner.
This results in interest income and
expense being recognized at a constant
interest rate, based on the imputed bal—
ance of the loan. Example 1: A corporation, C, makes a
$200,000 no—interest loan for a term of two
years to an employee, E, on jan. 1,2005.
The AFR is 12%, compounded semi—
annually.The present value of the $200,000
loan is $158,418.73. C is treated as making a loan of
$158,418.73, with a maturity value of
$200,000. C and E have OID of
$41,581.27, which is reported as com—
pensation expense by C and compen—
sation income by E. Additionally, C
will have interest income and E will have interest expense of $19,580.56 for Exhibit 1: Two-year loan of $200,000 paying no interest AFR 12%, compounded semi-annually Balance January 1 Interest for year Balance December 3] $l58,4l8.73 $19,580.56 $177,999.29 $177,999.29 2005 and $22,000.71 for 2006, as
shown in Exhibit 1, above. Example 2: The facts are the same as in Ex—
ample 1, except that C made. the $200,000
no—interest loan to a shareholder, S. C is treated as making a loan of
$158,418.73, with a maturity value of
$200,000, and a distribution of
$41,581.27 to Sin 2005 that is treated
as a dividend or return of capital under
Sec. 301.The OID of$41,581.27 will
result in interest expense for S and
interest income for C of$19,580.56 for
2005 and $22,000.71 for 2006. 8 reports the dividend (or return of
capital distribution) on the 2005 per—
sonal income tax return and will be
allowed a deduction for the imputed
interest payments in 2005 and 2006, if
the applicable requirements of Sec. 163
are met. However, C is not entitled to a
deduction for the imputed distribution
to S as an offset against its imputed
interest income. ' The IRS may View the entire loan
to S as a constructive dividend, rather
than just the amount of the imputed
interest on the loan.This is more likely
if C fails to follow standard business
practices such as requiring a signed
note, collateral, a definite maturity date,
periodic interest payments, etc.When
such terms are established for a loan, it Loans between employers and employees, corporations and shareholders, and relatives provide
a number of planning opportunities. $22,000.71 $200,000.00 is important for all parties to comply with all of them. Under Sec. 7872(b), when a term
loan provides interest that is less than the
AFR, imputed interest is determined by
deducting the present value of interest
and principal payments from the loan
amount. If the loan in Example 1 pro—
vided interest at a 5% annual rate, the
present value of interest and principal
payments would be $175,239.63, result—
ing in imputed interest (CID) of
$24,760.37.Thus, C and E would have
interest expense or income of
$21,659.62 for 2005 and $23,100.75 for
2006, consisting of $10,000 of interest
paid each year plus imputed interest. Demand Loans With a “demand loan” the lender
may demand payment at any time. It is
not possible to compute OID by com—
paring the present value of the sched—
uled principal and interest payments
with the amount loaned, because the
loan does not have a fixed term. Under
Sec. 7872(a), for demand loans, the
lender has interest income (forgone
interest) equal to the excess of (1) the
interest that would have accrued on the
loan using the AFR over (2) any inter—
est actually paid on the loan.The parties
are treated as though, on the last day of
each calendar year, the lender trans—
ferred an amount equal to the forgone
interest to the borrower, and the bor—
rower repaid this amount as interest to
the lender. Example 3 shows how
imputed interest is determined for a
no—interest demand. loan made to an
employee, a shareholder or as a gift. I Example 3: On]an.1, 2005, corporation X makes a $200,000 no—interest, demand
loan.The loan is outstanding for two years THE TAX ADVISER / JUNE 2006 353 Interesthwomefi’ExPeme — and the AFR is 12%, compounded semi—
annually The interest on the demand loan
from January through June is $12,000.
This forgone interest is added to the
loan balance, causing the forgone inter—
est from July through December to be
$12,720.Thus, the total imputed inter—
est income for 2005 is $24,720. X is treated as paying $24,720 to the
borrower at the end of 2005, and the
borrower is treated as transferring that
amount back to X. The effects of this
loan are shown in Exhibit 2 at right for
(1) a compensation—related loan, (2) a
corporation—shareholder loan and (3) a
gift loan. Withholding Imputed Interest on
Loans from Foreign Persons Temp. Regs. Sec. 1.7872—5T de—
scribes situations in which a loan from a
foreign person is not covered by Sec.
7872. However, compensation—related
loans and certain corporation—sharehold—
er loans are not excluded by the regula—
tion.Thus, if the below—market loan is
from a foreign corporation, the imputed
payment of interest may be subject to
withholding tax under Sec. 881, at the
rate of 30% (which may be reduced by
treaty). For example, in Climazo,9 aJapan—
ese corporation made a $200,000, zero—
interest loan to a shareholder, for the pur—
chase of a home in the US. The
shareholder withheld and paid a 10%
withholding tax (low treaty rate) on the
imputed interest payments to the Japan—
ese corporation. The taxpayer filed a
claim for refund, based on the position
there was no requirement to withhold
such taxes, because no actual payments
were made. However, the court held that
such withholding was required. No—Interest Term Loans that Are
Gift Loans It is generally necessary to compute
OID for below—market term loans to
determine the amount of the deemed
transfers between a borrower and a
lender. However, for income tax pur— 9 Climate, ED NY, 1/19/96. 354 THE TAX ADVISER / JUNE 2006 Exhibit 2: Effect of no-interest demand loan described in Example 3 Type of Loan ' Lender Compensation-
related loan Borrower lnterest income of $24,720 interest expense of $24,720 Compensation expense of $24,720 Compensation income of $24,720 Corporation-share-
holder loan lnterest income of 524,720 Interest expense of $24,720 Dividend paid of $24,720 Dividend income of $24,720 Gift loan Interest income of $24,720 interest expense of $24,720 poses, Congress chose to apply the
“forgone interest” approach to gift
loans that are term loans. Congress
believed familial or other close personal
relationships are likely to exist between
the borrower and the lender where
there is a gift loan.These relationships
may cause the parties to view the tech—
nical provisions of the loan, such as
mat...
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