Editor: Albert B. Ellentuck, Esq.
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 written documentation is prepared, and no interest rate or repayment schedule is set up. Such haphazard treatment can lead to unexpected and costly tax consequences in the event of an IRS audit. In most cases, the IRS will try to characterize the phantom payment to the shareholder for the forgone interest as a dividend, thereby denying the corporation an offsetting deduction for the interest income it is deemed to have received. The best way to avoid such treatment is to ensure that the corporation documents as loans all funds it loans to shareholders and that the shareholders pay interest on the loans at rates not less than the applicable federal rate (AFR).
If imputed interest on a loan is treated as compensation, payroll taxes must be considered. On a demand loan, the forgone interest and related compensation (i.e., the deemed transfers) are deemed to occur on December 31 each year. Fortunately, this fixes the time for calculating any FICA or FUTA tax due at the date on which the liability for these taxes is at a yearly low (because the employee’s year-to-date cash compensation will almost certainly exceed the FUTA limit and perhaps even the FICA limit, without considering the Medicare tax). If an employee’s compensation does not exceed the FICA tax wage limit before the addition of the imputed income, the corporation must make arrangements to collect the employee’s share of FICA (Prop. Regs. Sec. 1.7872-11(g)(4)).
These rules also apply to a term loan that is treated as a demand loan because of the requirement that the employee perform future services to receive the loan (Prop. Regs. Sec. 1.7872-10(a)(5)). For all other compensation-related term loans, the transfer of income is deemed to occur on the date the loan is made. Therefore, the liability for payroll taxes on these types of term loans can arise at any time during the year.
Loans from Shareholders
The income tax effect of imputing interest on loans from shareholders may not appear to be as detrimental as that resulting from loans to shareholders (which can result in taxable income at the corporate and shareholder level with no offsetting deductions). However, loans from a shareholder to a corporation are often made when a business is incurring net operating losses. As a result, the corporation may not benefit from any imputed interest expense, and the shareholder still has imputed interest income. Furthermore, loans that are reclassified as paid-in capital cannot be recovered until the corporation is liquidated or the stock is sold.
Indirect Below-Market Loans
Certain transactions may be restructured as two loans, one direct and one indirect. In Rountree Cotton Co., the Tax Court upheld the “ordering approach” used in Prop. Regs. Sec. 1.7872-4(g) as an effective way to address the issue of indirect loans. In such cases, the ability to make these loans depends on the shareholder relationship of the indirect participant. Therefore, the whole amount of the loan is first attributable to the shareholder’s relationship with the lender. After that point, the flow from the lender’s shareholder to others, whether partners, nonshareholders, or some other relationship, will be subject to Sec. 7872 if the transaction falls under those rules.
A lender and a borrower may use another person as an intermediary in structuring a loan. If a purpose for using the intermediary is to avoid the below-market rules pertaining to corporation/shareholder loans or compensation-related loans, the intermediary is ignored and the loan is treated as made directly between the lender and the borrower (Prop. Regs. Sec. 1.7872-4(g)(2)). An IRS field service advice contains a detailed discussion of these rules (FSA 199916006).
Exceptions to the Sec. 7872 Rules
The Sec. 7872 imputed interest rules do not apply to loans between an employer and an employee, or a corporation and a shareholder, if the aggregate outstanding amount does not exceed $10,000 (Sec. 7872(c)(3)(A)). Once term loans become subject to the below-market rules, that treatment continues to apply even if the outstanding balance is later reduced to $10,000 or below (Sec. 7872(f)(10); Prop. Regs. Sec. 1.7872-9(a)). But if one of the principal purposes of the interest arrangement is to avoid taxes, the below-market rules apply even if the loan balance is below the $10,000 threshold (Sec. 7872(c)(3)(B)).
Another exception relates to loans made for an employee’s relocation. The relocation must involve a move to begin work at a new principal workplace at least 50 miles farther from the employee’s old residence than was the previous principal workplace. If the employee had no former principal workplace, the new principal workplace must be at least 50 miles from the old residence. Under these circumstances, a loan secured by a mortgage on the new residence is exempt from the imputed interest rules if benefits of the interest arrangement are (1) not transferable, (2) conditioned on the employee’s performance of future services, and (3) expected (as certified by the employee) to be itemized tax deductions while the loan is outstanding (Temp. Regs. Sec. 1.7872-5T(c)(1)(i)).
Bridge loans used to purchase a new residence are also exempt from the imputed interest rules if (in addition to the preceding conditions for a relocation loan) (1) the loan agreement provides that the bridge loan is payable in full within 15 days after the sale of the employee’s old residence, (2) the loan is not greater than the employer’s reasonable estimate of the employee’s equity in the old residence, and (3) the employee does not convert the old residence to business or rental use (Temp. Regs. Sec. 1.7872-5T(c)(1)(ii)).
The America’s Recovery Capital Loan Program allows small business borrowers to get a loan from a Small Business Administration–approved lender to in turn make payments on their own qualifying debt. The SBA pays interest to the lender and provides a 100% guarantee of payment to the lender. In Chief Counsel Advice 200943028, the IRS concluded that the interest paid by the SBA to the lender is not taxable to the small business borrower under Temp. Regs. Sec. 1.7872-5T(b)(5), which exempts loans that are subsidized by a federal government agency and are available to the public under a program of general application.
Planning Considerations with Low Interest Rates
A demand loan is a below-market loan if interest is payable at a rate less than the AFR, while a term loan is a below-market loan if the amount loaned exceeds the present value of all payments due under the loan using the appropriate AFR for the month the loan is made. This means that when a corporation charges at least the AFR on a shareholder loan, the below-market interest rules are avoided. This usually is the best option, except when no interest can be charged under the $10,000 de minimis rule.
Because the AFRs have fallen so low, now is a good time to consider (1) making additional low-interest loans to shareholders, (2) replacing existing higher-interest shareholder loans with new ones that charge lower rates, or (3) converting demand loans to term loans to lock in the low rates. To reiterate, as long as a corporation-to-shareholder loan charges an interest rate equal to the AFR, the complexities associated with the below-market interest rules are avoided.
This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 23d Edition, by Albert L. Grasso, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, Mary C. Danylak, Timothy Fontenot, James A. Keller, Michael E. Mares, and Brian B. Martin, published by Thomson Tax & Accounting, Ft. Worth, TX, 2010 ((800) 323-8724; ppc.thomson.com ).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.