United States: How Can "Friendly" Loans Impact Your Tax Liabilities?

It is not uncommon for a related or “friendly” party to desire to make a loan at a lower interest rate than what is available in an arms-length transaction on the open market. This is often the case when loans are made between relatives, business owners and their businesses, and employers and their employees. However, if the lender does not charge enough interest, the transaction may give rise to unforeseen and unintended tax liabilities. The applicable federal rate (“AFR”) is a statutory interest rate that sets the minimum amount of interest that must be charged on any loan.¹ If a loan’s interest rate is lower than the AFR, the lender is treated as if they received additional income in the amount of any foregone interest that would have been received had the loan’s rate been set at the AFR.² This amount is referred to as “imputed interest” and a loan which accrues interest at a rate below the AFR is called a “below-market loan.” As a result of imputed interest being treated as income, the lender must pay tax on imputed interest.³ The borrower can generally deduct any interest amount imputed to the lender.⁴

Term Loans

Tax law divides loans into two categories: (1) demand loans and (2) term loans.⁵ A demand loan is a loan that is payable in full at any time on the demand of the lender.⁶ A term loan is any loan which is not a demand loan.⁷ Term loans are broken down into short-term, mid term, and long-term loans. A loan with a term of three years or less is a short-term loan, a loan with a term between 3 years and 9 years is a mid-term loan, and a loan with a term of over nine years is a long-term loan.⁸

Each month the Internal Revenue Service (“IRS”) releases a Revenue Ruling listing the short-term, mid-term, and long-term AFR in effect as of that month. To ensure that a term loan will not be characterized as a below-market loan, the lender simply needs to charge interest at the applicable AFR in the monthly Revenue Ruling in which the loan is made.⁹ For example, if a shareholder loans Acme Corporation $1,000 in July 2017, payable in full in July 2018, the shareholder needs to charge interest at a 1.22 percent rate (the short-term rate in effect as of July 2017).¹⁰ Even if the short-term rate increases in subsequent months, the parties do not need to adjust the loan’s rate; the 1.22 percent rate can be locked over the entire loan period.

Demand Loans

Determining the AFR is more complicated in the context of demand loans. The AFR for a demand loan is the short-term rate in effect for each semiannual period of the loan.¹¹ The two semiannual periods run from January 1 through June 30 and from July 1 through December 31. Thus, calculating the AFR for a demand loan requires the parties to adjust the loan’s interest rate at least semiannually, and is sometimes referred to as a “floating rate.” To illustrate, if a shareholder loans Acme Corporation $1,000, payable on demand, on January 1, 2017, the loan must accrue interest at a 0.96 percent rate (the semiannual short-term rate for January 2017) until June 30, 2017.¹² On July 1, 2017, the loan’s rate must be adjusted to 1.22 percent (the semiannual short-term rate for July).¹³ The loan’s interest rate needs to be adjusted in this fashion each January 1st and July 1st until the loan is paid in full.¹⁴

However, not all demand loans commence in January or July. If a demand loan commences in any other month, the interest rate charged for the loan’s first period is either the short-term AFR (with semiannual compounding) for (a) the month in which the loan begins; or (b) the first month of that semiannual period (January or July).¹⁵ The parties can choose the lower of these two rates.¹⁶ Suppose in February 2017, Acme Corporation is again in need of cash from the shareholder. The rate for the first period of the loan can be either (i) 1.04%, the semiannual short term rate for February;¹⁷ or (ii) 0.96 percent, the semiannual short-term rate for January (the first month of the semiannual period). In July (the start of a new semiannual period), if the loan has not been repaid, the rate must be adjusted to July’s semiannual short-term rate of 1.22 percent.

Because calculating the AFR for a demand loan requires the application of a semi-annual floating rate, charging a fixed-rate on a demand loan may result in the loan being characterized as a below-market loan. In the examples given above, if on January 1 the shareholder made a loan to Acme Corporation at a fixed 1.0 percent interest rate, the loan would be characterized as a below market loan as of July 1. The semiannual short term rate for January was 0.96 percent, which was less than the fixed 1.0 percent being charged, but became 1.22 percent on July 1, which was higher than the fixed 1.0 percent being charged. Consequently, if the parties decide to charge a fixed rate on a demand loan, the loan documents should provide that the interest rate will always be the greater of the stated fixed rate and the special rate for demand loans as set forth in the Internal Revenue Code (“Code”) and its regulations.

Loans with an Indefinite Maturity

If a loan has an indefinite maturity, it may not clearly fit the Code’s definition of a term loan or demand loan. Consequently, the application of the AFR to such a loan is not entirely clear. A loan which matures upon a liquidity event, such as the sale of a business, is an example of a loan with an indefinite maturity. A loan maturing upon the sale of a business does not have a defined term to which the mechanical short-term, mid-term, or long-term rate can be applied because it is unknown when the business will be sold. At the same time, the loan is not payable on demand of the lender, but rather payable upon the occurrence of a future specified event.

Congress recognized this issue and gave the Treasury Department the authority to treat loans with indefinite maturities as demand loans “to the extent provided in the regulations.”¹⁸ The Treasury Department has not exercised this authority, and neither the proposed or final regulations address how the AFR should be applied to loans with indefinite maturities. This led the Tax Court in KTA-Tator, Inc. v. Commissioner ¹⁹ to hold that loans with indefinite maturities are term loans. It argued that because the Treasury Department has yet to pass regulations treating loans with indefinite maturities as demand loans, and because the Code defines term loans as any loan which is not a demand loan, loans with indefinite maturities are term loans by virtue of the fact that they are not demand loans.²⁰ The court, perhaps conveniently, did not have to deal with the issue of whether the short-term, mid-term, or long-term rate applied because it decided that the loan at issue did not have an indefinite maturity. Instead, the court found the loan was payable on demand, and thus was a demand loan.

To date, KTA-Tator is the only decision to address this issue. However, Tax Court decisions are generally not binding precedent on the federal courts.²¹ Accordingly, whether a federal court would agree with the Tax Court’s conclusion is unclear. The statute’s legislative history points out that “often it is impractical to treat a loan with an indefinite maturity as a term loan, since section 7872 requires the computation of the present value of payments due under such a loan.”²² More fundamentally, if loans with indefinite maturities are treated as term loans, how do the parties decide whether the short-term, mid-term, or long-term rate is applicable without knowing the length of the loan? This is the question KTA-Tator left unanswered.

One option is to include a backward looking provision in the loan’s terms. Such a provision would provide that once the loan does mature, and the term of the loan is known, the parties, will recalculate whether enough interest was charged over the loan period by looking at the applicable rate on the date the loan was executed. For example, if a loan executed on July 1, 2017, matures on July 1, 2023, the parties would look back to the mid-term AFR as of July 1, 2017, and compare it with the rate that was actually charged. If the rate charged was less than the applicable AFR, the loan documents would require that the borrower will pay the lender any foregone interest to avoid violating the Code.

Using the long-term rate for a loan with an indefinite maturity will ensure compliance with the AFR because, as the highest rate under the AFR scheme, a lender could not have imputed interest over and above the amount provided by the long-term rate. Of course, the drawback of this strategy is charging a comparatively high rate of interest to a party who the lender may desire to grant preferable loan terms. Beyond incorporating a backward looking provision or charging the long-term rate, a lender will have to base its decision on what rate to charge by assessing how much risk it is willing to accept. The short-term or mid-term rate could be used, but if the loan does not mature in the applicable time period, the lender will have imputed interest. Another strategy would be to treat a loan with an indefinite maturity as a demand loan and continually adjust the short-term rate every semiannual period, as detailed above.  This strategy would be in contravention of the one decision on record, however, and would require the taxpayer to convince a court that KTA-Tator should not be followed.

Special thanks to Taylor Cammack for research and drafting assistance with this article. 

Footnotes

1 See generally I.R.C. §§ 1274, 7872.

2 I.R.C. § 7872(a).

3 I.R.C. §§ 1, 61(a)(4).

4 See H. Conf. Rept. 98-861, at 1015 (1984), 1984-3 C.B. (Vol. 2), 1, 269; I.R.C. § 163.

5 I.R.C. § 7872(f)(2).

6 I.R.C. § 7872(f)(5).

7 I.R.C. § 7872(f)(6).

8 I.R.C. § 1274(d).

9 See I.R.C. §§ 7872(f)(2)(A), 1274(d).

10 See Rev. Rul. 2017-14, Table 1, https://www.irs.gov/pub/irs-drop/rr-17-14.pdf

11 I.R.C. § 7872(f)(2)(B). Note that interest must be compounded semiannually for both term loans and demand loans. See I.R.C. § 7872(f)(2)(A)–(B). For the sake of simplicity, this article ignores the effects of compound interest.

12 See Rev. Rul. 2017-2, 2017-2 I.R.B. 364, https://www.irs.gov/pub/irs-drop/rr-17-02.pdf

13 See Rev. Rul. 2017-14, 2017-27 I.R.B. 2, https://www.irs.gov/pub/irs-drop/rr-17-14.pdf

14 I.R.C. § 7872(e)(2)(A) permits the use of a “blended annual rate” for demand loans with a fixed principal amount outstanding for an entire calendar year. The blended annual rate is the product of (1) one-half of the January semiannual short-term AFR times (2) one half of the July semiannual short-term federal AFR. See Rev. Rul. 86-17, 1986-1 C.B. 377.

15 Prop. Reg. § 1.7872–(b)(3).

16 Prop. Reg. § 1.7872–(b)(3); Prop. Reg. § 1.7872(c)(3) Ex. (5)(i).

17 See Rev. Rul. 2017-4, 2017-6 I.R.B. 776, https://www.irs.gov/pub/irs-drop/rr-17-04.pdf

18 I.R.C. § 7872(f)(5).

19 KTA-Tator, Inc. v. Commissioner, 108 T.C. 100 (1997).

20 Id. at 104.

21See, e.g., Nico v. Commissioner, 67 T.C. 647, 654 (1977), aff ’d in part and rev’d in part, 565 F.2d 1234 (2d Cir.).

22 S. Rept. 99-313, at 958 (1986), 1986-3 C.B. (Vol. 3) 1, 958.  

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.