Case study: avoiding the below-market rules on corporation/shareholder loans.

• Author: Ellentuck, Albert B.

THE BELOW-MARKET LOAN RULES APPLY to all advances, notes, and receivables between a shareholder and a corporation, regardless of the shareholder's level of ownership (Sec. 7872(c)(1)(C); Prop. Regs. Secs. 1.7872-4(d) and 1.7872-2(a) (1)).

Loans to Shareholders

If the corporation makes a loan to a shareholder, the imputed amount is considered transferred from the corporation to the shareholder as a dividend or compensation. If the shareholder is not an employee, the imputed amount is treated as a dividend. If the shareholder is an employee, the imputed amount normally is treated as a dividend if the employee owns more than a de minimis amount of stock. However, if clear and convincing evidence can prove that the loan is made solely in connection with the performance of services, it may be treated as compensation even when the employee owns a substantial amount of stock (Prop. Regs. Secs. 1.7872-4(c) and (d)).

For closely held corporations, stock ownership exceeds a de minimis amount when a shareholder owns (directly or indirectly) (1) more than 5% of the total voting power of all classes of stock entitled to vote; (2) more than 5% of the total number of shares of all other classes of stock; or (3) 5% of the total value of shares of all classes of stock (including voting stock) (Prop. Regs. Secs. 1.7872-4(c) and (d)(2)(ii)).

The imputed interest is deemed paid by the shareholder to the corporation. The corporation must recognize income but has an offsetting deduction if the amount is treated as compensation. The shareholder must recognize compensation or dividend income but has interest expense, which may be deductible depending on how the borrowed funds are used. (For example, if used for personal purposes (other than a residential mortgage), the interest would be nondeductible personal interest.)

Observation: The Tax Court has made it clear that the IRS can impute interest under Sec. 7872 on below-market loans from a corporation to noncontrolling shareholders (Rountree Cotton Co., 113 T.C. 422 (1999), aff'd, 12 Fed. App'x 641 (10th Cir. 2001)). The court acknowledged that the cases decided before and after the enactment of Sec. 7872 involved controlling shareholders. The court noted, however, that those cases "do not reflect any consideration of a threshold requirement that below-market loans be made to a majority shareholder."

A corporation often advances funds to its shareholders with little thought about the possible tax consequences. No...