Benefiting from employer below-market-rate loans.

• Author: Ellentuck, Albert B.

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...