Imputed Interest – When Being Nice Bites Back
Recently a client requested that we review a Promissory Note for a loan that he was giving to a friend. There was no security being offered nor any Deed of Trust against real estate. And even better for the borrower, he wasn’t going to charge any interest…0%. This very nice gesture by our client was certainly welcomed by his friend. But unknown to them both, a hidden penalty was lurking, a penalty called “Imputed Interest”.
What is Imputed Interest:
Years ago, the IRS noticed that many loans were being made to various close parties (family, friends, etc) in which the lenders were charging low or no interest. This deprived the IRS from taxes that, they believed, would have been paid if a normal interest was charged. They called the potential interest generated by these loans “imputed income”. The Tax Act of 1984 provided a mechanism that allows the IRS to collect tax on this imputed interest income even though no interest payment has actually been made. The tax code calls for imputed interest because some people and organizations have tried to dodge taxes by portraying large gifts, additional compensation, dividends and other taxable payments as loans.
When is it Charged:
Imputed interest comes into play when someone makes a “below-market” loan. That’s a loan with an interest rate below a certain minimum level set by the government, known as the Applicable Federal Rate, or AFR. The AFR mandates a minimum interest rate for any loan made below a certain interest rate threshold. As explained by Seattle accountant and tax specialist Scott Usher, the government expects loans to be “structured in a business-like manner,” including interest rates that reflect market conditions. The idea is that if you’re not charging and collecting a certain level of interest, the government isn’t going to take your word for it that this is a loan.
How it Works:
For example, a couple loans their son $100,000 interest free. Assume the applicable short term federal rate is 2%. The amount of interest the son should be paying his parents would be $100,000 x .02 = $2,000. The IRS would then make an assumption that the annual interest charge the parents should have collected from the son would be $2,000. The IRS would then expect this amount to be listed on the parents’ tax return as interest income even though they never received a penny, hence imputed. The parents would then have to pay income tax on that $2,000.
How to Determine the Tax:
Every month, the IRS publishes a list of the current Applicable Federal Rates, which reflect market conditions. For example, in April 2016, the AFR for loans of less than 3 years is 0.46%.
For loans maturing in 3 to 9 years, it is 1.12%. And for long term loans (10 or more years) the AFR is 2.25%. If you charge less than the applicable AFR, you have to deal with imputed interest. If you do charge interest but it is less than the applicable AFR, you will be imputed to have received the difference and end up being taxed as if you had received the full AFR amount.
What Loans does it Apply to:
The rules for below-market loans apply to several kinds of loans including (1) Gift loans between friends and family members other than spouses; (2) Compensation-related loans from an employer to an employee or independent contractor; (3) Loans from a corporation to one or more of its shareholders; and (4) Any loan made specifically to reduce someone’s tax responsibility.
There are a number of exceptions which apply in some situations, most particularly when the amount is less than $10,000 or where the loan would be “without significant tax effect”.
Need more Information:
If you believe that a loan you have made or are considering making might subject you to imputed interest, contact your accountant or CPA for their evaluation. You can also learn more from various IRS publications, including Publication 550, at www.IRS.gov.
At BPE Law Group, P.C. we advise business and property owners, real estate agents, and individuals on how to understand and deal with issues as they arise and, where necessary, we provide legal representation. If you need our assistance, please contact me at firstname.lastname@example.org or call our office at (916) 966-2260 to arrange a consultation.
This article is not intended to be legal advice, and should not be taken as legal advice. Every case requires review of specific facts and history, and a formal agreement for service. Please feel free to contact us if you need legal advice and are interested in seeing if we can help you.