Understanding Interest-Free and Below Market Rate Loans

1. Interest-Free And Below Market Rate Loans • There are few tax advantages to an interest-free or below market rate loan due to the denial of all personal interest deductions, and the limitation of investment interest deductions to investment income • Most of these loans are between • A corporation and non-shareholder employee • Parent to child or other family member • Economic advantage lies in the borrower’s ability to use either the funds or the interest from the funds

2. When Is Use Of Such A Loan Appropriate? • To reduce the estate of the lender by limiting the future growth in the value of the assets • To shift economic wealth to the borrower • As a corporate fringe benefit to allow an employee to • Purchase a home • Provide for a child’s education • Purchase stock of the employer-corporation • Pay life insurance premiums • Pay medical bills

3. When Is Use Of Such A Loan Appropriate? • Transfer of income through interest-free or below market rate loans can be used to • Support parents • Provide support for children in school • Help family members purchase a home or business

4. What Are The Requirements? • Transaction must constitute a bona fide debt, preferably in writing • If parties maintain books or records of account, the debt should be entered • There should be a provision in the debt instrument expressly precluding interest, or stating the below market rate to be charged

5. What Are The Requirements? • To assure a loan from a corporation to an employee is not construed as compensation income the following requirements must be met: • Arrangement must constitute a bona fide debt • Preferably in writing • Containing a reasonable repayment schedule or a note payable on demand • A demonstrated intent to repay must be evidenced by an agreement between the parties, otherwise the IRS could claim the loan is a disguised compensation • Amount of the loan must be reasonable in relation to the salary of the employee

6. What Are The Requirements? • Avoid situations where the corporation borrows money to make interest-free loans to shareholders

7. How Is It Done? • Good Example • Mom advances her daughter a $150,000 interest-free loan to enable her daughter to purchase a new home • Note: Interest income will be imputed to mom

8. How Is It Done? • Bad Example • Rich, Tony, and Larry each own 1/3 of their family business • Business creates interest-free loan agreements with each of them • In order to make the loans, the business had to have the company’s suppliers extend substantial amounts of credit • Rich, Tony, and Larry personally guarantee the obligations to the business suppliers • Every time the business pays interest to the creditors it is acting like an agent for Rich, Tony, and Larry, and in essence discharging the personal obligations of the shareholders • To the extent actual payments are made, Rich, Tony, and Larry are deemed to have received dividend income and made an interest payment

9. Tax Implications • Loans with no interest or below market rate interest are re-characterized for tax purposes as loans bearing a market rate of interest accompanied by a payment or payments of interest from lender to borrower, and are subject to general rules for interest deductions • “Phantom payments” are the difference between what should have been charged and what was in fact charged for the use of the money lent

10. Tax Implications • Phantom payments will be re-characterized as: • Compensation from a business to an employee • Dividend from corporation to its shareholder • Gift from shareholders of corporation to borrower • Gift from parent to child • Gifts of phantom payments may be subject to gift tax

11. Issues In Community Property States • State gift taxes on interspousal gifts: • If money lent is separate property but the note is made in favor of both spouses • If money lent is community property and the demand note only favors one spouse • Money lent to one spouse was used to purchase assets in the names of both spouses • Use of community funds or separate property of a non-borrowing spouse to repay the separate loan of the borrowing spouse • Avoid a gift in this instance, by the borrower spouse giving the non-borrowing spouse or the community a note for the amount of the funds used to repay the separate obligation