Neither a lender nor a borrower be, said Shakespeare―but for many of us, that’s just not practical advice.
Jack’s son, Liam, is buying a vacation home―a rambling place on a lake that’s big enough for their large extended family. Liam’s been looking for the perfect place for awhile. Now that he’s found it, in the current financial climate, he’s having trouble finding a lender. Jack would like to loan his son the money.
Mia’s company is experiencing the credit crunch first-hand―its line of credit has been cut dramatically. The business is left without access to the funds necessary to take on a major new project. Mia would like to loan her business the money.
Sean was recently promoted to a senior executive position at work and, as a result, has been given the opportunity to purchase an equity interest in the company. Because Sean doesn’t have the necessary funds to buy stock in this rapidly growing and closely held business, the company would like to loan him the money.
Jack, Mia, and Sean are each considering what is commonly referred to as a related-party loan, and they all have questions about the tax implications. Are they required to charge interest? If so, how much must they charge? Are there any other IRS requirements to consider?
Federal Tax Implications of Below-Market Loans
Loan interest payments impact the federal income tax liability of the lender and, often, the borrower. The lender must report the interest earned as income for federal tax purposes, even if the borrower is a family member, friend, or the lender’s closely held business. The borrower may be able to deduct the interest payments, depending on how the loan proceeds are used.
Obviously, no-interest and below-market-rate loans reduce the taxable income of lenders and, correspondingly, tax revenue for the IRS. Such loans are more common in situations where the borrower and lender are related parties―for example, members of the same family, friends, or shareholder and closely held business.
Not surprisingly, the IRS requires that loans be structured in a business-like manner, with terms that reflect current market conditions. For a loan with terms that it deems too favorable, the IRS has the ability to recharacterize the loan―perhaps as a gift, additional compensation, or a corporate dividend or distribution―with all the tax implications that such a recharacterization implies.
For no-interest or below-market interest loans the IRS also has the right to increase the interest rate for tax purposes by requiring that the lender report more interest than was actually received under the terms of the loan. The interest for tax purposes is calculated based on the Applicable Federal Rate (AFR), as described below. The specific rules for such additional, imputed (or phantom) interest vary somewhat depending on the type of loan―gift, term, or demand.
From a federal income tax perspective, the below-market loan rules and AFRs apply in any of the following situations:
certain loans made to qualified continuing care facilities under a continuing care contract
Applicable Federal Rates (AFRs)
Each month the IRS publishes interest rates for federal income tax purposes, referred to as Applicable Federal Rates, or AFRs. They represent the minimum acceptable interest rates for most loans. If your loan’s interest rate at the inception of the loan is equal to or exceeds the relevant AFR, the IRS cannot challenge the appropriateness of the rate during the term of the loan.
AFRs include annual, semiannual, quarterly and monthly rates for short-term loans (terms of three years or less), mid-term loans (terms over three years but not exceeding nine years) and long-term loans (terms longer than nine years).
To ensure that the IRS recognizes your loan as a loan for tax purposes and does not consider it to be a potentially less favorable transaction―a gift, additional compensation, or a corporate divided or distribution, for example―you should have a written loan document or promissory note.
The document should be signed and dated by the borrower and describe the terms of the loan. It should include the loan amount and interest rate, as well as the payment schedule and any other terms. If your borrower is providing collateral, include a detailed description.
Below-Market Loan Rules
If the IRS determines that the interest rate for your loan is below the prescribed minimum established by the AFR, the loan is subject to the below-market loan rules.
Generally these rules require the lender and borrower to recognize interest income and interest expense for federal tax purposes based on the relevant AFR rather than the loan’s actual interest rate. The greater the difference between the loan’s interest rate and the relevant AFR, the more imputed interest the borrower will be required to report and pay taxes on.
For a demand loan, without a fixed loan term and end date, the AFR used to calculate interest for tax purposes varies each month, based on fluctuations in the AFR. For a term loan, with a documented loan term and end date, the interest calculation is based on the relevant AFR as of the loan’s start date.
It’s important to note that there are a number of exceptions to the below-market loan rules. These exceptions include loans where the total amount outstanding between lender and borrower does not exceed $10,000, a loan that does not exceed $100,000 if the borrower’s net investment income doesn’t exceed $1,000, and a loan where the interest terms do not significantly affect the lender’s or borrower’s federal tax liability.
Tax Planning Opportunities
Minimum federal interest rates for tax purposes, as established by the AFRs, are near historic lows. As a result, it may be advantageous to renegotiate your higher-interest related-party loans.
If you have an undocumented loan, this might be the time to formalize it with a promissory note. Without documentation, the IRS considers your loan to be a demand loan, and the imputed interest rate for tax purpose will change each month based on fluctuations in the AFR.
If you are planning a new related-party loan, the low minimum interest rate may make this an attractive time to complete the transaction. If you create a new term loan now, when the AFR is near an all-time low, you can lock in a very favorable interest rate.
The tax rules governing below-market and related-party loans are complex, with a number of exceptions. To understand all of the tax implications, consult your tax advisor at Bader Martin before you enter into or renegotiate any loan.