Chapter 5

Part 2
 Below-Market Loans
• Interest-free or below-market-rate loans are
frequently made between related parties
• Interest income that is not actually received or
accrued may be imputed (treated as received
or accrued and taxed) at the applicable federal
rate of interest
 Below-Market Loans
• Typical Income Shifting Plan
– High-bracket loans $100,000 to low-bracket
– Transfer is a loan rather than a gift to ensure control
– Loan is a demand loan enabling continuous control
– Low bracket taxpayer invests the $100,000 to produce
investment income
– Investment income is taxed at low rate
– Loan is interest free so no income at high-bracket
• §7872 enacted to attack these loop holes
 Below-Market Loans
– Hypothetical treatment.
• As if the borrower/debtor paid interest to the lender who
subsequently transfers an equal amount back to the borrower
 Below-Market Loans
• Impute interest
– Borrower/debtor deemed to pay interest to the lender who
subsequently transfers an equal amount back to the borrower
– Result:
• Lender treats hypothetical “payment” from borrower as income
(thus moving the income back to the lender)
• Borrower may have deduction for the “payment”
• Lender’s payment to Borrower is treated as gift, compensation or
dividend, depending on relationship.
 Below-Market Loans
• Hypothetical Treatment

Interest income to lender L

Deemed interest payment
L B

Interest free demand loan

Gift, Compensation, Dividend
 Gift Loan Exceptions
• Any gift loan of $10,000 or less is exempt from the
imputed interest rules
– No tax consequences if loans outstanding never exceed $10,000
during year unless
• A gift loan and borrower uses loan proceeds to purchase or carry
income producing assets
• A nongift loan and one of its purposes is tax avoidance
• For gift loans greater than $10,000 but less than
$100,000
– Imputed interest cannot exceed the borrower’s net investment
income for the year
– If borrower’s net investment income is no more than $1,000,
imputed interest is zero
 Other Loans
• Loan to employee – loan interest is imputed income
to employer, returned to employee as compensation;
taxable compensation to employee and deductible by
employer
• Loan to shareholder – loan interest is imputed
income to corporation, returned as dividend to
shareholder; taxable dividend to shareholder but no
corporate deduction
• $10,000 exception if no tax avoidance motive
Chapter 5- homework problems
• Problems to review
– 27, 28, 30, 31, 32, 47