One of the more confusing aspects of taxation is the federal mandate for a business to charge interest on loans to or from its owners. This is primarily targeted at corporation/shareholder loans but can affect other business entities as well. Given current interest rates this requirement seems both senseless and immaterial. However, understanding these self-charged interest requirements requires a trip back in time to their enactment.
In 1984 the prime rate was over 10%. Congress foresaw potential abuses with owners taking loans from their businesses at no interest and vice versa. Congress saw these loans creating unjust enrichment, enabling loans between related parties without any cost to borrow. In an effort to curb these perceived abuses, Sec. 7872 was enacted as part of the 1984 tax overhaul (Deficit Reduction Act of 1984, P.L. 98-369). This Code section required loans between certain related parties, usually in excess of $10,000, to bear a minimum amount of interest based on the applicable federal rates (AFRs).
This new Code section immediately ran into a complication from a much older law, Sec. 267, which governs transactions between related parties. While the vast majority of individuals are cash-method taxpayers, many businesses operate on the accrual method. Accrual-method businesses can deduct expenses as they are incurred, but cash-method individuals do not recognize income until actually received. As such, an interest payment from an accrual-method business to its individual owner that is not paid, merely accrued, would be deducted by the business, but would not be income to the owner until it is paid. Sec. 267 steps in and forbids the deduction when a related party would not recognize the corresponding income.
At first it would appear the old law, Sec. 267, would defang the new law, Sec. 7872. However, since Sec.7872 was enacted after Sec. 267, it is read as a modification of Sec. 267. Because Sec. 7872 mandates a minimum amount of interest income, regardless of payment, to be recognized by the related party lender, a cash-method related-party lender is forced to recognize some interest income. It effects this result by deeming the interest to be original issue discount. In turn, some relief is provided to the accrual-method borrower, who may now claim a deduction to the extent the related cash-method lender is required to recognize the income.
Unfortunately, when both the owner and the business are cash-method taxpayers, and Sec. 267 is not the limiting factor, the results are a bit different. If no interest is actually paid, Sec. 7872 still mandates the recognition of a minimum amount of interest income by a related-party lender. However, since the borrower in this case is cash method, it cannot deduct the related interest expense until paid.
The resulting dichotomy of treatment can cause basis differences for book and tax purposes, as well as between the lender and borrower. For example, an accrual-method business might accrue the face amount 5% rate on a loan from its cash-method owner for book purposes, but not actually pay anything. If the relevant AFR rate for calculating the prescribed Sec. 7872 minimum interest is only 1%, the business's book basis of the debt would increase by the 5%, but the tax basis in the debt would only increase by the 1% AFR. So, for tax and book purposes the business's debt has different basis that needs to be considered when payments are finally made.
Likewise, if both shareholder and corporation are cash-method taxpayers and payments are not made, the debtor and lender will have different tax basis in the debt. In this situation the lender, required to recognize income not yet received, would have a higher basis than the borrower of the debt. These differences need to be carefully tracked by each party for recognizing income and expenses when payments are made at a later date.
While corporation/shareholder loans are the primary focus of Sec. 7872 (along with gift and compensation-related loans, which are outside the scope of this discussion), partnership/partner loans can also be pulled into this arena. Sec. 7872(c)(1)(D) includes a catchall provision for tax avoidance loans, defined as "any below-market loan 1 of the principal purposes of the interest arrangements of which is the avoidance of any Federal tax."
This is less clearly defined than the automatic applicability of a corporation/shareholder loan, specified under Sec. 7872(c)(1)(C), but if the purpose of the partner/partnership loan is to reclassify a distribution in excess of basis, it would presumably apply, requiring self-charged interest on the debt. A similar argument could be made for a partner/partnership loan that increased the partner's at-risk basis, allowing a loss to be recognized.
Net investment income tax
Another complication for self-charged interest involves the net investment income tax under Sec. 1411. As interest income, even though not actually received, the mandated income recognition under Sec. 7872 would inherently be subject to the additional tax. Fortunately, Regs. Sec. 1.1411-4(g)(5) has additional rules for self-charged interest, borrowing from Regs. Sec. 1.469-7, to alleviate some of this issue.
Under this provision, only self-charged interest income from a passthrough that results in a reduction of income subject to self-employment tax is subject to the additional tax. Unfortunately, this rule applies only to passthrough entities, not C corporations. That means self-charged interest income to S corporation shareholders and limited partners is not subject to the additional tax. Only general partners, those LLC members treated as such, and shareholders in C corporations are subject to the net investment income tax on self-charged interest.
More concerning is what can happen if the required interest is not calculated and subjected to administrative scrutiny. One path mandates having the parties adjust their interest income and expense accordingly. This has been the result in most court cases involving Sec. 7872. If the amounts are sufficient, this can result in not only tax and interest, but penalties as well.
There is another, less fortunate path this can take. Failure to charge adequate interest can be viewed as indicia of a sham transaction disguising a dividend. Under this regime, the loan would be reclassified as a constructive dividend. For a shareholder of a C corporation this could create a taxable dividend.
The shareholder of an S corporation could have a distribution in excess of basis or a taxable distribution of accumulated earnings and profits. It could also create a disproportionate distribution, bringing an effective preferred stock into existence and disqualifying the S election. Any flowthrough owner could have a loss disallowed under the ordering rules for lack of basis under this scenario. Though the courts do not appear to go down this route often, it would result in much greater taxes, interest, and penalties, as well as potential complications in the case of an S corporation saddled with disproportionate distributions, than simply recognizing the statutory interest income.
Pay attention to the rules
With short-term rates well under 1%, and calculation thresholds as low as $10,000, the resulting amounts of self-charged interest can seem a waste of effort. This can be particularly true given the Byzantine interactions of Secs. 7872 and 267, and their tangential effects on the tax imposed under Sec. 1411.
However, if disregarded and challenged, there is not only the potential for interest and penalties, but also reclassification resulting in substantial potential income, loss denial, and/or disproportionate distributions. In summary, what may seem immaterial could have much larger effects, and the rules for mandated interest should not be disregarded in the name of efficiency.
— Damien Falato, CPA, CGMA, MST, is a tax director at Paresky Flitt & Company LLP, Wayland, Mass. For comments on this article or suggestions of other topics, contact Sally Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com.