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.

• Author: Godfrey, Howard

EXECUTIVE SUMMARY

* 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.

* The below-market loan rules may apply to a variety of transactions, including loans between employers and employees, corporations and shareholders, and relatives.

* 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.

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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 ruled (1) 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 loam. 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 loam.

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 under 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 include:

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 Tax (5); however, under Sec. 7872(f)(9) income tax withholding is not required on this income. An independent contractor tractor is subject to the same rules for recognition of income, but...