Interest-Free and BelowMarket Rate Loans
Chapter 37
Tools & Techniques ofEstate Planning
Copyright 2011, The National Underwriter Company
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•There are few tax advantages to an interest-free or belowmarket rate loan due to the denial of all personal interestdeductions, and the limitation of investment interest deductionsto 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 eitherthe funds or the interest from the funds
Interest-Free And Below Market Rate Loans
Interest-Free and BelowMarket Rate Loans
Chapter 37
Tools & Techniques ofEstate Planning
Copyright 2011, The National Underwriter Company
2
•To reduce the estate of the lender by limiting the future growth inthe 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
When Is Use Of Such A Loan Appropriate?
Interest-Free and BelowMarket Rate Loans
Chapter 37
Tools & Techniques ofEstate Planning
Copyright 2011, The National Underwriter Company
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•Transfer of income through interest-free or below market rateloans can be used to
–Support parents
–Provide support for children in school
–Help family members purchase a home or business
When Is Use Of Such A Loan Appropriate?
Interest-Free and BelowMarket Rate Loans
Chapter 37
Tools & Techniques ofEstate Planning
Copyright 2011, The National Underwriter Company
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•Transaction must constitute a bona fide debt,preferably in writing
•If parties maintain books or records of account, thedebt should be entered
•There should be a provision in the debt instrumentexpressly precluding interest, or stating the belowmarket rate to be charged
What Are The Requirements?
Interest-Free and BelowMarket Rate Loans
Chapter 37
Tools & Techniques ofEstate Planning
Copyright 2011, The National Underwriter Company
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•To assure a loan from a corporation to an employee is notconstrued as compensation income the following requirementsmust be met:
–Arrangement must constitute a bona fide debt
•Preferably in writing
•Containing a reasonable repayment schedule or a note payable ondemand
–A demonstrated intent to repay must be evidenced by anagreement between the parties, otherwise the IRS could claim theloan is a disguised compensation
–Amount of the loan must be reasonable in relation to the salary ofthe employee
What Are The Requirements?
Interest-Free and BelowMarket Rate Loans
Chapter 37
Tools & Techniques ofEstate Planning
Copyright 2011, The National Underwriter Company
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•Avoid situations where the corporation borrows money to makeinterest-free loans to shareholders
What Are The Requirements?
Interest-Free and BelowMarket Rate Loans
Chapter 37
Tools & Techniques ofEstate Planning
Copyright 2011, The National Underwriter Company
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•Good Example
–Mom advances her daughter a $150,000 interest-free loan toenable her daughter to purchase a new home
•Note: Interest income will be imputed to mom
How Is It Done?
Interest-Free and BelowMarket Rate Loans
Chapter 37
Tools & Techniques ofEstate Planning
Copyright 2011, The National Underwriter Company
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•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 thecompany’s suppliers extend substantial amounts of credit
•Rich, Tony, and Larry personally guarantee the obligations to thebusiness suppliers
•Every time the business pays interest to the creditors it is actinglike an agent for Rich, Tony, and Larry, and in essencedischarging the personal obligations of the shareholders
•To the extent actual payments are made, Rich, Tony, and Larryare deemed to have received dividend income and made aninterest payment
How Is It Done?
Interest-Free and BelowMarket Rate Loans
Chapter 37
Tools & Techniques ofEstate Planning
Copyright 2011, The National Underwriter Company
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•Loans with no interest or below market rate interestare re-characterized for tax purposes as loansbearing a market rate of interest accompanied by apayment or payments of interest from lender toborrower, and are subject to general rules for interestdeductions
•“Phantom payments” are the difference betweenwhat should have been charged and what was in factcharged for the use of the money lent
Tax Implications
Interest-Free and BelowMarket Rate Loans
Chapter 37
Tools & Techniques ofEstate Planning
Copyright 2011, The National Underwriter Company
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•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
Tax Implications
Interest-Free and BelowMarket Rate Loans
Chapter 37
Tools & Techniques ofEstate Planning
Copyright 2011, The National Underwriter Company
11
Issues In Community Property States
•State gift taxes on interspousal gifts:
–If money lent is separate property but the note is made in favorof both spouses
–If money lent is community property and the demand note onlyfavors one spouse
–Money lent to one spouse was used to purchase assets in thenames of both spouses
–Use of community funds or separate property of a non-borrowingspouse 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 thefunds used to repay the separate obligation