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Interest-Free And Below Market Rate Loans

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

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Interest-Free And Below Market Rate Loans

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  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

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