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Below-Market Loans May Have Unexpected Tax Results Tax advisers should be aware of the type of arrangements subject to imputed interest rules under Sec. 7872. This article describes the major types of below-market loan transactions, as well as the exceptions and how the rules apply to such transactions. Howard Godfrey, Ph.D.,
CPA Robert Guinn, Ph.D., CPA Edward Malmgren, Ph.D.,
CPA For more information about this article, contact Professor Godfrey at hgodfrey@email.uncc.edu.
Executive Summary
Sec. 7872 recharacterizes a “below-market” loan as an arms-length transaction in which the lender makes a loan to the borrower 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 payment 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 transferred a valuable property right. The transfer of $100,000 in cash, interest-free,…is similarly a grant of the use of valuable property....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. 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 borrower, 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 interest payments, or requires such payments at a rate below a statutorily defined rate. Congress intended that “loan” be interpreted broadly to include extension of credit. Any transfer of money that provides the transferor with a right to repayment 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 maturity. 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 (AFR). Interest is imputed on a term loan when the loan amount exceeds the present value of the principal 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 formula that analyzes interest rates on Federal obligations of appropriate maturity. Each month, the IRS publishes 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 interest 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 example, if the AFR is 10%, a loan that pays interest at the rate of 10% per year is a below-market loan if it requires annual compounding. A 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. 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 Loan Transactions Under Sec. 7872(c)(1), transactions involving imputed interest rules in-clude: 1. Compensation-related loans between 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)(1)(B), a below-market loan by an employer to an employee for the performance of services is a compensation-related loan. An independent contractor may receive a compensation-related loan from a person to whom the independent contractor provides services. An arrangement is compensation-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 compensation-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 exchange. This 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 contractor 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 corporation 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 capital. The borrower (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 shareholder 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 continuing care facility may require refundable deposits from individuals who become residents. This type of loan 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 principal purposes of the interest arrangement 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 classified as a compensation-related or a corporate-shareholder loan. Other arrangements: Sometimes, the classification of the imputed payments depends on the transaction’s substance. For example, according to Prop. Regs. Sec. 1.7872-1(a), an interest-free loan to a charitable organization is a loan on which adequate interest 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 additional compensation for the other entity. The Committee Reports for Sec. 7872 include an example of an investment 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 property 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 taxpayer agreed to accept $4.8 million for redemption of her stock in a closely held corporation in a divorce settlement in 1991. The price was to be paid over a period of years and the note did not bear interest. The divorce agreement 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 nontaxable under Sec. 1041. The Eleventh Circuit found that the redemption was not taxable under Sec. 1041, and accordingly found there was no imputed interest under Sec. 1274. This treatment was included in proposed regulations 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 property 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 Ruling 86450828 addressed these issues for a note given to equalize the distribution 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 further reasoned that the parties negotiated 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 settlement.
Determining and Reporting Imputed 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 of all 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 day. The present value is computed using the AFR in effect on the loan date. Sec. 1272 requires the lender to recognize a portion of the OID as interest income each period. Sec. 163(e) 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 balance of the loan.
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 compensation expense by C and compensation income by E. Additionally, C will have interest income and E will have interest expense of $19,580.56 for 2005 and $22,000.71 for 2006, as shown in Exhibit 1.
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 S in 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. S reports the dividend (or return of capital distribution) on the 2005 personal 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 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 provided interest at a 5% annual rate, the present value of interest and principal payments would be $175,239.63, resulting in imputed interest (OID) 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 comparing the present value of the scheduled 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 interest actually paid on the loan. The parties are treated as though, on the last day of each calendar year, the lender transferred an amount equal to the forgone interest to the borrower, and the borrower 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.
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 interest from July through December to be $12,720. Thus, the total imputed interest 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 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-shareholder loans are not excluded by the regulation. 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 Climaco,9 a Japanese corporation made a $200,000, zero-interest loan to a shareholder, for the purchase of a home in the U.S. The shareholder withheld and paid a 10% withholding tax (low treaty rate) on the imputed interest payments to the Japanese 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 purposes, 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 technical provisions of the loan, such as maturity, as not being binding on the parties. However, for gift tax purposes, Sec. 7872(d)(2) provides a term gift loan is subject to the OID rules and not the forgone interest rules. This means the lender is treated as making a gift, subject to the gift tax rules, in the amount of the OID.
The present value of the $200,000 payment discounted for two years at 12% compounded semiannually is $158,418.73. This means there is OID of $41,581.27 (see Example 1 above). For income tax purposes the parties use the forgone interest approach summarized in Example 3. P is treated as paying $24,720 to S at the end of each year, and S is treated as transferring that amount back to P as interest. However, for gift tax purposes, P should report a gift of $41,581.27 on Jan. 1, 2005.
Exceptions for Small Loans and Continuing Care Loans Sec. 7872(c)(2) provides interest is not imputed for gift loans between individuals, unless the total amount of the loan(s) exceed $10,000, or the loan is related to the purchase or carrying of income-producing assets. For a gift loan that is not more than $100,000, imputed interest is limited to the borrower’s “net investment income” under Sec. 7872(d)(1). This exception does not apply if one of the principal purposes is the avoidance of any Federal tax. When a borrower has more than one gift loan, the net investment income is allocated among those loans in proportion to the loan amounts. If a borrower’s net investment income is not more than $1,000, the net investment income is treated as zero under Sec. 7872(d)(1)(E). Net investment income includes any amount which would be included in the gross income under Sec. 1272 if that section applied to all deferred payment obligations. A deferred payment obligation includes any market discount bond, short-term obligation, U.S. Savings Bond, annuity or similar obligation. This definition of net investment income includes some types of income not currently subject to income tax. Under Sec. 7872(c)(3), interest is not imputed for compensation-related or corporation-shareholder loans if the total amount of the loan(s) does not exceed $10,000. This exception does not apply to tax-avoidance loans. Once the balance of the loan exceeds $10,000, Sec. 7872 continues to apply even if subsequent payments reduce the balance below $10,000. Sec. 7872(g)(2) limits the amount of forgone interest or OID amortization for a below-market loan made by a lender to a qualified continuing care facility under a continuing care contract if the lender (or the lender’s spouse) is over age 65. The Code describes the types of facilities covered by the exception and notes that a facility of a type traditionally considered a nursing home is not covered. For 2006, there is no imputed interest for a no-interest loan up to $163,300 to a continuing care facility. This amount is adjusted for inflation each year.
Planning Suggestions Loans made between employers and employees, corporations and shareholders, and relatives provide a number of planning opportunities. The tax adviser should be aware of other arrangements that may be subject to imputed interest rules and of the exceptions to Sec. 7872, especially those that relate to small loans and continuing care facilities. Exhibit 3 contains a partial list of loans exempt from Sec.7872 and other transactions which involve loans that may be exempt, depending on the circumstances involved. The following suggestions can minimize the effect of Sec. 7872. 1. Use care in establishing terms of a loan to a relative, friend, employee or shareholder; specify a rate at least equal to the AFR to avoid the necessity of imputing interest income to the borrower. 2. When planning a below-market loan between a corporation and a shareholder, consult the IRS publication Audit Technique Guide for Shareholder Loans (June 2001). To avoid having to treat the entire loan as a constructive dividend, there should be a written note, collateral, a stated maturity date and required periodic interest payments. In addition, the lender should enforce the terms of the loan and the borrower should comply with those terms. 3. Be aware of the types of loans that are not covered and those which are covered by Sec. 7872; see Exhibit 3. 4. When determining whether a be-low-market gift loan qualifies for an exclusion based on the level of investment income, recognize that investment income includes items that may not be reported on Form 1040, such as an increase in value of U.S. Savings Bonds. 5. The aging population in the U.S. will have an increasing need for medical care. The Sec. 7872 exception for below-market loans for continuing care provides a way to realize the benefit from earnings on investments without being subject to income tax on that income. 6. If a below-market loan is made, properly account for forgone interest or amortization of OID and comply with all reporting requirements for Form W-2 or 1099, etc. 7. When involved in gift tax planning or compliance, be sure to include any gift loans in the gift tax computations as required by Sec. 7872(d)(2). 8. When involved in estate planning or compliance, be sure to include any gift loans in the estate tax computations as required by Sec. 7872(h)(2).
Conclusion Below-market loans may yield surprises when they involve an exception to the time-honored rule that borrowing money is not a transaction that generates income. The borrower may be treated as receiving an imputed gift or imputed income, and may have imputed interest expense. The lender may have to recognize imputed interest income and possibly have an offsetting expense as a result of making a loan. Information returns may be required and the transactions could be subject to payroll, income tax and/or gift tax. |
