Secure interest-free loans for company shareholders

Banks recently lowered their interest rates nationwide. Now it won't be as painful for clients to borrow funds if a family needs cash for an unexpected home repair or some other emergency. But business owners might do even better than a low-interest loan from the bank.

Strategy: Arrange a no-interest loan from a client's company to the owner. This fringe benefit is perfectly legal, but some drawbacks exist:

1. The business owner is subject to tax on this benefit.

2. The company could be socked with a tax bill for "phantom income" it never receives.

To avoid this result, the client should establish in the corporate minutes that the loan is being made for compensatory reasons. Although the business owner will still owe tax on the compensation, at least the company will be entitled to an offsetting compensation deduction.

Background information: When a no-interest or a below-market loan is made by a company to an employee, the "below-market interest rules" take effect. Under this provision, the IRS treats the company as having made a phantom payment to the employee, an amount equal to the interest that wasn't charged. In turn, the employee is treated as having used this phantom payment to pay interest on the loan.

If the payment is deemed compensation, the company reports the additional income on the employee's W-2. On the other hand, if a business owner receives the interest-free loan because he or she is a shareholder, it's taxed as a dividend. Either way, the company is charged with receiving taxable income equal to the phantom payment, even if the owner isn't actually paying any interest on the loan.

Key difference: The company writes off phantom payments treated as compensation just like wages paid to other employees. But phantom payments treated as dividends aren't deductible by the company.

And, if a client is a 5-percent-or-more shareholder, phantom payment is treated as a dividend unless "clear and convincing evidence" can prove that the transaction is compensatory in nature.

To establish that the phantom payment represents compensation, have the client spell out the loan details in the corporate minutes. The client should explain that the loan is made for compensatory reasons and list the valuable services the shareholder-employee provides the company.

The client almost must show that the company has a policy of providing compensatory loans by offering the same type of loan to key employees who are not shareholders. Finally, maintaining the company's traditional dividend-paying history while the loan is outstanding also will help.

Note that the timing of the income and deductions under the below-market interest rules depends on whether the loan is a "term" loan or a "demand" loan.

  • With a term loan, the owner repays the loan over a specified term. Therefore, the company gets a bigger current compensation deduction for the phantom interest, while the shareholder-employee has more taxable income in the year the loan is made.

  • With a demand loan, both the payments and the income are determined on an annual basis. Thus, the company's compensation deductions and the employee's compensation income are spread over the term of the loan.

    Is the owner entitled to any offsetting deductions? It depends on how the loan proceeds are used. If the money is used for personal purposes, he or she receives no deduction.

    However, if the deemed interest qualifies as deductible investment interest or mortgage interest, it may offset all or part of the taxable compensation. If handled correctly, this effectively creates a tax-free fringe benefit for a business owner.

    Advisory: The below-market interest rules don't apply to loans of less than $10,000. So the entire issue may be avoided on a small, interest-free loan from the company.

    Reprinted with permission from "The Tax Strategist," April 2008. For continuing advice on this and numerous other tax strategies, go to www.TaxStrategist.net. Receive 2 FREE Bonus Reports and a 40 percent discount on "The Tax Strategist" when you use Promo Code WN0013.

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