Below-Market Interest Loans

The Internal Revenue Service (IRS) looks very suspiciously at loans that carry little or no interest. These loans, called below-market interest loans, can either be demand loans with interest payable at less than the statutorily prescribed applicable federal rate or term loans where the amount of the loan exceeds the present value of all payments due under the loans.

In general, the IRS will recharacterize these below-market interest loans as if they were arm's length transactions in which the lender made a payment to the borrower equal to the amount of interest waived by the lender. The deemed "payment" from the lender to the borrower is treated as a gift, dividend, contribution to capital, compensation, or other payment, depending upon the type of loan involved. To complete the recharacterization, the IRS treats the transaction as if the borrower retransferred the amount of the interest back to the lender as interest. Therefore, in the fiction created by the IRS, the lender received interest income while the borrower had interest expense, which is deductible to the same extent as any interest expense of the same kind. The amount and timing of these transfers and retransfers depends upon whether the below-market interest loan is considered a gift or a demand or term loan.

For any below-market interest loan that the IRS characterizes as a gift or demand loan, the imputed interest amount is considered to have been transferred from the lender to the borrower on the last day of the calendar year of the loan.

The IRS characterizes all below-market interest loans that are not gift or demand loans as term loans. In the case of term loans, the lender is deemed to have transferred to the borrower an amount equal to the excess of the amount loaned over the present value of all payments required under the loan.

The below-market interest loan rules apply to gift loans, compensation-related loans, corporation-shareholder loans, tax avoidance loans, and any other below-market loans where the interest arrangement between the parties has a significant effect on the federal income tax liability of either the lender or the borrower.

A de minimis exception applies to certain types of loans. If a loan is a gift loan of $10,000 or less between individuals and is not attributable to the acquisition of income-producing assets, the IRS will not enforce the below-market interest loan rules. When a gift loan between individuals does not exceed $100,000, the amount imputed to the lender will not exceed the borrower's annual net investment income. If that income is less than $1,000, there will be no deemed transfer of imputed interest to the lender.

In addition, there is also a $10,000 de minimis exception for compensation-related or corporation-shareholder loans where the IRS does not find tax avoidance as the principal purpose. Other IRS rules exempt certain below-market interest loans by individuals to continuing care facilities pursuant to a contract.

Copyright 2010 LexisNexis, a division of Reed Elsevier Inc.