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Benefiting from Employer Below-Market-Rate Loans Editor: This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 7th Edition, by Anthony J. DeChellis and Patrick L. Young, published by Practitioners Publishing Company, Ft. Worth, TX, 2006 ((800) 323-8724; ppc.thomson.com). When a loan’s interest rate is below market (determined by the IRS each month), interest is imputed under a series of complex rules under Sec. 7872. If an executive loan fails to provide for adequate interest (i.e., equal to the applicable Federal rate (AFR), payable at least annually), the company is deemed to transfer additional compensation (or dividends, if the executive is a shareholder) equaling the forgone loan interest for the period the loan is outstanding. The executive, in turn, is deemed to pay the forgone interest to the company; see Sec. 7872(a)(1) and (c)(1).
Problems Executives encounter
problems with these rules when they cannot deduct the deemed interest payments
to the company because the loan proceeds are used for investment, passive or
personal use. (Interest on loan proceeds used for investment purposes is
subject to the investment interest limits; interest on loan proceeds used for
passive activities is subject to the passive loss rules. Interest on loan
proceeds used for personal use (other than for a qualified personal residence
or, in some instances, higher education costs) is nondeductible.) In such
cases, the executive has imputed interest income, but no offsetting deduction to
the extent the interest deduction is limited or disallowed.
Example 1 Alan is the president of
Computer Technologies, Inc. (CTI). He borrowed from it $100,000, interest-free.
The loan is payable on demand and will be used for personal purposes. The
required interest rate (i.e., the AFR rate) is 4%. If Alan makes no loan
repayment during the first year, he has $4,000 imputed compensation income
(equal to the forgone interest). He also has a $4,000 potential interest
expense deduction, because he is deemed to pay the forgone interest back to the
company. However, interest on personal-use loans is not deductible, under Sec.
163(h)(1); thus, Alan will owe tax on the $4,000 income. Note: To avoid the imputed-interest rules, the tax adviser
should ensure that any loan from a company to an executive or a shareholder is
represented by a note, bears an interest rate at least equal to the AFR and
calls for regular (i.e., at least annual) interest payments.
When a Below-Market Loan Is Still Beneficial As a result of the
imputed-interest rules, below-market or interest-free loans are not as popular
as they once were. However, they can still be advantageous to an executive from
an overall economic standpoint, especially when AFRs
are low.
Example 2 The facts are the same as in
Example 1. Alan has a 40% combined Federal, state and local tax rate. Because
of the imputed-interest rules, he is out-of-pocket $1,600 ($4,000 compensation
income × 0.4 tax rate) in taxes for the year. However, this amount is much
lower than the $8,000 interest expense he would have paid had the loan been
obtained from a bank (assuming an 8% interest rate). Thus, even after
considering the tax effect of the interest-free demand loan, he is still better
off borrowing from CTI than from a bank.
Exceptions Tax advisers may find the
following three exceptions to the imputed-interest rules useful when
structuring an executive loan. First, the imputed-interest
rules do not apply to loans between an employer and employee (or between a
corporation and a shareholder) if the aggregate outstanding amount of loans
between the borrower and lender is $10,000 or less; see Sec. 7872(c)(3). Second, the imputed-interest
rules do not apply to loans made for an executive’s relocation; see Temp. Regs.
Sec. 1.7872-5T(c)(1)(i). The
relocation must involve a move made because the executive has begun work at a
new principal workplace that is at least 50 miles farther from the executive’s
old residence than was the previous principal workplace. If the executive had
no former principal workplace, the new principal one must be at least 50 miles from
the old residence. Under these circumstances, a loan secured by a mortgage on
the executive’s new residence is exempt from the imputed-interest rules if the:
1. Loan is not transferable;
2. Loan is conditioned on the executive’s
performance of future services;
3. Executive certifies to the employer
that he or she expects to itemize deductions each year the loan is outstanding;
and
4. Loan agreement requires that the loan
proceeds be used only to purchase the employee’s new principal residence. Caution: The relocation loan exception may not be available
if the executive is a shareholder. The IRS may assert that the loan was made
because the executive is a shareholder, rather than because services are being
performed. Any loan between a corporation and an employee-shareholder should be
approached cautiously, even if the interest rate is at fair market. The Service
may assert that the loan is, in substance, a nondeductible dividend. Third,
under Temp. Regs. Sec.
1.7872-5T(c)(1)(ii), bridge loans used to purchase a new residence are exempt
from the imputed-interest rules if (in addition to the preceding conditions for
a relocation loan) the:
In the case of either a relocation or bridge loan, the practitioner
should advise the executive to open a separate bank account for accepting and
disbursing the borrowed funds. This will prevent the commingling of the funds
with any other loan proceeds and ensure that the monies can be traced to the
purchase of a new residence. |
