Imputed Interest On Below-Market Loans
Imputed interest rules were designed to prevent high bracket taxpayers from shifting income to lower bracket relatives. Before 1984, income could be shifted between taxpayers with interest-free loans. For example, a mother has $100,000 invested in a bond. She wants to keep the bond but allow her son to earn the interest, so she gives the bond to her son in exchange for a non-interest-bearing note payable to the mother on demand. The mother retains the right to receive $100,000 while the son earns income from the bonds. Significant tax savings are realized if the son is in a lower tax bracket than his mother.
To prevent this type of scenario, Congress implemented new tax rules that recognize imputed interest as income. Tax law treats the imputed interest as a gift that was earned by the mother and given to the son. Although there may also be a gift tax liability on the mother, the mother has to recognize the interest as income while the son is considered to have received the gift for which he does not pay taxes.
The rate of imputed interest, which must be compounded semiannually on any applicable loans, is calculated using the 3 applicable federal rates (AFR) published monthly by the IRS:
- short term loans, where loan term ≤ 3 years, including demand loans
- mid-term loans, where 3 years < loan term ≤ 9 years
- long-term loans, where loan term > 9 years
If the rate of interest charged is less than the AFR, then the imputed interest is equal to the difference. Imputed interest rules apply to:
- gift loans;
- compensation related loans, such as employer loans to employees;
- corporation shareholder loans, where a corporation lends money to its shareholders;
- tax avoidance loans that significantly lessen either party's tax liability.
Compensation related loans are considered a compensation expense to the employer and compensation income to the employee. Loans by a corporation to its shareholders are considered interest income to the corporation, while the borrowers receive dividend income. So that the IRS will see a loan as a bona fide loan, the loan should have the following characteristics:
- based on a written instrument with the repayment schedule or a note payable on demand
- intent to repay the loan as evidenced by the loan agreement
- the amount of the loan must be reasonable considering the employee’s salary or compensation
If the loan is to a shareholder-employee, then it could be interpreted as a dividend. In some cases, the corporation acts as an agent, borrowing money from a 3rd party, then lending the money to shareholders or employees. In these cases, the IRS will interpret the transaction as a dividend paid to the borrowers, who then paid the interest on the loan.
Tax avoidance loans are a nonspecific type of loan to cover tax avoidance schemes that are often dreamed up by lawyers and accountants, such as the following. The taxpayer joins a health club with membership fees of $400 per year. The taxpayer can make an arrangement to give the health club a $5,000 deposit on which it can earn 8% interest which would be equal to the $400 membership fee. This arrangement allows a taxpayer to earn the benefit of the interest without paying any taxes on it.
There is a specific type of commercial loan that does not fall under the compass of the imputed interest rules — prepayments. If a business receives prepayments that are included in the business's income under its method of accounting, then the prepayments are not subject to imputed interest rules.
Imputed interest rules also do not apply to:
- gift loans of $10,000 or less (aka de minimis loans), unless it is used to purchase income producing property, in which case, the following $100,000 rule applies.
- loans of $100,000 or less. If the loan is used to purchase investment property, then imputed interest rules do not apply if the net investment income from the property does not exceed $1,000.
If net investment income is greater than $1,000, then the gross investment income is the lesser of the imputed interest, as calculated by using the AFR, or the actual gross income earned, since the objective of the imputed interest rules was to prevent income shifting. Net investment income is gross income from all investments minus related expenses.
Net Investment Income = Gross Investment Income – Investment Expenses
If Net Investment Income ≤ $1,000 then Imputed Interest = 0
Else: Net Investment Income = Lesser of (Imputed Interest Computation or Actual Gross Investment Income) – Investment Expenses
However, if the primary purpose of the $100,000 loan was tax avoidance, then the interest is imputed and not limited by the borrower's net investment income, since the purpose of the imputed interest rules was to prevent high tax-bracket taxpayers from shifting income to lower bracket relatives.
Example — $100,000 Exception to Imputed Interest Rules
You make a $100,000 interest-free loan to your daughter payable on demand. Your daughter's gross investment income for the year is $5,000 and her investment expenses total $300. Assuming that the AFR on a short-term loan is 4%, then, for the 1st tax year (remember that tax law stipulates that imputed interest be compounded semiannually):
- Net Investment Income = $5,000 – $300 = $4,700
- For 1st Half Year: Imputed Interest = $100,000 × .04 × .5 = $2,000
- For 2nd Half Year: Imputed Interest = $102,000 × .04 × .5 = $2,040
- Imputed Interest for the Entire Year = $2,000 + $2,040 = $4,040
- Therefore, Net Investment Income = Lesser of ($4,040 or $5,000) – $300 = $4,040 – $300 = $3,740
You will have to report the $3,740 of net investment income for the year on your tax return. Your daughter does not have to report the income, since tax law deems the net investment income to be a gift. If your gift was for more than the gift tax annual exclusion (2015, $14,000), then you would also have to report the value of the gift minus the exclusion on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return.
Loans to relatives can still be beneficial, even if imputed interest rules apply, since the AFR is usually far below the interest rates that most lenders would charge to consumers, especially since the target interest rate set by the Fed is so low.