Interest-Free Loans to Shareholders
An Opportunity to Reduce Overall Tax Costs

By William A. Duncan, John O. Everett, and Sharon S. Lassar

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The authors explore a number of permutations of personal and corporate tax circumstances and analyze the tax savings or costs associated with each strategy and discuss the tax policy implications of recent and future legislation in this area.

Prior Law

IRC section 7872 requires that forgone interest on below-market loans be treated as a transfer from the lender to the borrower. The language does not require that this transfer be treated as interest. If the borrower is an employee, the forgone interest is compensation subject to employment taxes but not federal income tax withholding. But if the borrower is a shareholder, the forgone interest is treated as a dividend. IRC section 7872 further provides that an amount equal to the forgone interest (the amount that would have been payable if calculated at the applicable federal rate over the amount payable under the terms of the loan) is then treated as if it were retransferred by the borrower to the lender as interest. This part of the transaction is specifically termed “interest.”

For a corporate employee, this pretended transfer and immediate retransfer will accomplish the same result as if an employee had been paid more and the increased pay had been devoted to the payment of the appropriate rate of interest to the lending company. The lending corporation will have both income and expense, which will net out (assuming payroll taxes are ignored).

Shareholder loans are treated much more unfavorably at the corporate level. Because the deemed transfer to the shareholder is a dividend, it is not deductible by the corporation (although payroll taxes are not due). Thus, any forgone interest will be taxable income to the corporation, and this tax payment is equal to the net reduction to earnings and profits.

Under the law as it existed before the Jobs and Growth Tax Relief Reconciliation Act of 2003, a shareholder would have had equal amounts of interest expense and dividend income. If the interest was nondeductible personal interest, the taxpayer (if in the top tax bracket) would have then paid 38.5% of the forgone interest in federal tax, because dividends were taxable as ordinary income (in addition to state and local taxes, which are beyond the scope of this article). If the loan was used for investment purposes, the interest would have been deductible if the taxpayer had investment income. And because the dividends were investment income, the two amounts should have canceled each other out, resulting in no net cost to the shareholder. All of the cost would have been borne by the corporation that paid tax on the interest deemed paid to it by the shareholder. The actual cost depended on the corporation’s marginal tax rate and could have been as high as 39%.

Effects of the New Rate on Dividends

The reduction of the tax rate on dividends to 15% (5% for taxpayers in the 15% or 10% brackets) changes the calculus for the shareholder. The Exhibit sets out the possible tax consequences for the shareholder and the corporation, assuming that the shareholder is in the top marginal federal tax bracket and that the corporate rates vary from 35% to zero [if the corporation has a net operating loss (NOL)]. It assumes a loan of sufficient size that the resulting pretended transfers of interest and dividend between corporation and shareholder equal $10,000 when the applicable federal rate (AFR) is applied.

The net cost columns present the net of the various corporate costs and the shareholder tax costs from the first column. The baseline for assessing the usefulness of the following strategies is whether they are superior to the payment of a dividend and the associated 15% tax liability. Thus, any strategy that costs the shareholder and the corporation, together, more than 15% ($1,500, in this example) should have some other nontax advantage or be rejected.

Case A assumes that the shareholder uses the loan for personal purposes and cannot deduct any of the interest expense from the deemed payment. As a consequence, only the dividend is included in the shareholder’s taxable income, and the shareholder pays $1,500 in federal tax. The corporation has $10,000 of taxable interest income and pays the appropriate tax. Under no circumstances does this appear to be a desirable arrangement for tax purposes.

Case B assumes the loan will result in investment interest expense but that the shareholder does not have any other sources of investment income. In this case, the only way the shareholder can deduct the investment interest expense is by electing to have the deemed dividend income taxed at ordinary income rates. [IRC section 1(h)(11)(D)(i) excludes from the 15% rate those dividends taken into account for purposes of the section 163(d) investment income limitation.] This strategy is attractive only if the corporation has an NOL.

Case C assumes that the shareholder has sufficient investment income from sources other than the deemed dividend to allow the deduction of all deemed investment interest from the loan. The result is that the investment income and the interest expense offset and leave the dividend income as the sole taxable item. The interest expense deduction yields tax savings of $3,500 ($10,000 x 35%) and the dividend income has a tax cost of $1,500 ($10,000 x 15%), for a net tax savings to the shareholder of $2,000. In effect, the interest income is transformed into favorably taxed dividend income. The overall net cost ranges from $1,500 to a savings of $2,000, depending on the effective corporate tax rates for the period. Thus, this strategy is either neutral (when the corporation is in the top marginal tax bracket, but not the 38% or 39% brackets) or advantageous (for lower brackets).

Case D assumes that the loan is used to purchase a principal or secondary residence, making the interest expense fully deductible. This alternative duplicates the tax consequences of Case C without the need to have sufficient investment income from other sources. On the other hand, Case C is not limited by the maximum debt caps of the home mortgage interest provisions and thus may be more useful to a wealthy shareholder.

The Corporation Borrows to Fund the Loan

In each of the prior examples, the corporation used monies on hand to fund the interest-free loan to the shareholder. A corporation could also borrow the money needed to fund the loan to the shareholder. In such an example, assume that the interest paid on the loan is exactly equal to the amount of interest imputed as a result of the application of the AFR (although the AFR will usually be somewhat lower than the actual cost to the corporation, making the actual cost of this transaction slightly higher than shown in this example).

In this case, the corporate marginal tax rate is not relevant. The corporation would have no additional tax liability, because the interest expense and the imputed interest income would offset. The corporation would be out the amount of interest actually paid to the lender, and earnings and profits would be adjusted accordingly. In effect, the corporation pays the interest due on the loan, and the shareholder, in the worst-case scenario, has an equal amount of taxable income.

If the imputed interest expense is deductible by the shareholder as an offset to the deemed dividend, the shareholder has no net increase in taxable income, nor any net tax savings. If the imputed transfer is taxable as a dividend because the taxpayer has other interest income or the interest is related to the purchase of a personal residence, as shown in Cases C and D above, the result is pure tax savings of 20% of the interest deemed paid.

If the corporation borrows to fund the loan, the corporation is gradually “bled” of the amount of assets expended to pay interest on the loan, and earnings and profits are reduced accordingly. In Cases C and D above, there is not only no net tax cost to the shareholder, but an actual reduction of the amount of tax otherwise paid. In effect, the shareholder would benefit from the corporate expenditure and save taxes at the same time.

S Corporation Shareholders

An interest-free loan from an S corporation to its sole shareholder would, absent earnings and profits, have no effect on the shareholder or the corporation. The deemed interest expense at the shareholder level would be offset by the deemed interest income at the S corporation level, which, of course, flows through to the shareholder. The deemed distribution would have no income tax effect, and because it matches the amount of income at the corporate level, the S corporation is unchanged by the transaction. If the S corporation has earnings and profits from a C corporation tax year, it may elect to treat any distribution as coming from earnings and profits first. The result is a reduction in earnings and profits at the cost of a net tax of 15%. This is no different from the tax cost that would have resulted had the corporation simply distributed a dividend to the shareholder. Given the alternative of making such a distribution and then lending the money back to the S corporation, the interest-free loan strategy seems too convoluted and risky to be worthwhile.

Family Tax Planning

Assume that a 100% corporate owner sells or gives 1% of the stock to her son, a low-income college student. The corporation lends money interest-free to the student-shareholder for the purchase of a primary residence near his college. The son has taxable income of less than $29,050 and is thus in the 15% marginal tax bracket. The deemed dividend is taxable to the son at a 5% rate, while the corporate tax consequences remain constant as shown in the examples above. [Proposed Regulations section 7872-4(d)(2)(ii) makes the loan a shareholder loan only if 5% or more (0.5, if public) is held by the borrowing employee/shareholder. But if the son is not an employee of the company, the deemed distribution must be a dividend.] The result is only a 10% savings (the net of an interest expense deduction at 15% and dividend income at 5%), compared to the 20% savings in the examples shown above. As a result, the total cost relationships are such that only the NOL case would be advantageous.

This assessment does not, however, completely capture the benefits of the transaction. Note that the deemed dividend is not pro rata. It represents a diversion of parental assets to the child, because the parent-shareholder owns the other 99% of the corporation. It is possible that such a transaction would cause the parent to be treated as having made a gift to the child. In this example, the gift is small enough to fall within the annual exclusion and is certainly a present interest qualifying for that exclusion. (The IRS might treat this as a dividend to the parent and a gift to the child, resulting in an additional 10% federal tax due to the parent’s higher tax bracket. Alternatively, the IRS could argue that this was an “indirect loan” through the parents to the child. See the discussion below.) Nevertheless, the uncertainties and risks surrounding this transaction probably limit its use to very special circumstances.

What Can the IRS Do?

IRC section 7872(h) gives the IRS broad authority to promulgate regulations, including adjustments to the provisions of IRC section 7872 to the extent necessary to carry out its purposes. The IRS issued proposed regulations in 1985 that were granted some deference by the Tax Court in a case of first impression [50 Fed. Reg. 33556-33569 (Aug. 20, 1985) and Rountree Cotton v. Comm., 113 TC 422, aff’d 87 AFTR 2d 2001-1454 (CA10)]. The proposed regulations do not anticipate a favorable tax rate for dividend income and thus do not address a possible recharacterization. Could the IRS solve the problem by simply requiring that the distribution from the corporation to the shareholder be characterized as interest rather than tax-favored dividends? This would eliminate the tax cost to the corporation, because the interest expense would presumably be deductible, although an argument about whether this is an ordinary, necessary, and reasonable amount might be adduced. If the deemed transfer is interest, the shareholder would be in a position to offset the two interest amounts, assuming that the conditions of deductibility in Cases B, C, or D were met. This would eliminate the “laundry” or conversion aspects of the transactions presented above, but it would also mean that interest-free loans would be cost-free to the shareholder. In effect, the shareholder would benefit from the earnings and profits of the corporation without ever paying tax. The only way the authors see that the IRS could prevent such a conclusion would be to adopt inconsistent positions with respect to the deemed transfer: a dividend at the corporate level and interest income to the shareholder. Even with legislative regulatory authority, this would seem to be an untenable position.

IRC section 7872(h)(1)(B) calls for regulations to ensure that the positions of the borrower and the lender be consistent. In Rountree Cotton, the Tax Court interpreted this provision to mean that regulations should ensure that “both parties to the transaction would or would not be subject to the effect of section 7872.” A loan by Rountree to another entity was treated as a loan to Rountree’s shareholders, who then reloaned the principal to the second entity as specified in Proposed Treasury Regulations section 1.7872-4(g)(1)(i) and (ii) regarding indirect loans. Both shareholders and nonshareholders of the lending corporation had ownership interests in the borrowing entity. Dividend income was imputed on the entire principal of the first loan even though Rountree’s shareholders owned less than 100% of the borrower and therefore enjoyed less than 100% of the economic benefit of the below-market loan.

The court did not address the economic benefit enjoyed by owners of the second entity that were not shareholders of Rountree, but noted that any such benefit would have been conferred by Rountree’s shareholders. If the issue had been addressed, it is possible that a portion of the second loan would have been a gift loan with another portion being a shareholder-corporation loan. Although “consistent treatment” might be interpreted to mean that the IRS should allow appropriate deductions to a party to a deemed loan as if the interest had actually been paid, the authors believe it unlikely that the IRS would propose new regulations to recharacterize what is now dividend income as interest income.

Could the IRS use the catch-all tax avoidance provision of IRC section 7872(c)(1)(D) to attack a transaction with an interest laundry consequence? The authors do not think so. Below-market tax-avoidance loans could simply be recast as loans at the AFR.
Finally, could the IRS take the position that deemed dividends on below-market loans do not qualify for the capital gains rate? Again, this is unlikely. IRC section 1(h) does not give the IRS this authority.

Variation: Excessive Employee Compensation

Analogous to an NOL situation, but at the other end of the economic spectrum, consider a corporation that finds itself in a position in which its payments to a corporate officer (and shareholder) exceed $1 million and the payments are not deductible for failure to meet performance targets [IRC section 162(m)(1)]. In these circumstances, there is no difference to the corporation whether it pays the employee-shareholder a nondeductible salary or a dividend. There is a distinct 20% difference, however, in the federal tax treatment for the recipient.

Here is what the corporation might consider in order to minimize the joint tax burden of the officer and the company when the shareholder-officer does not meet the performance targets required by IRC section 162(m)(4)(C). To the extent that compensation cannot be deducted for any year, the corporation makes the officer, who should also be a shareholder, an interest-free loan in an amount that allows the officer to maintain the expected annual cash flow. The loans are allowed to accumulate for those years during which performance targets are not met, and these loans are subsequently forgiven. Because the cumulative amount of the loans may be expected to have reached an amount such that forgiveness cannot be mistaken for reasonable compensation, the default position for federal tax purposes would treat the payment as a deemed dividend subject to tax at 15%. The advantages to the parties involved have been explained in earlier sections of this article. There is no marginal tax cost to the corporation, and it escapes the modest payroll taxes due on the compensation of the officer. More important, the officer-shareholder saves in two ways: The officer-shareholder saves 20% because of the tax-favored status of dividends, and the officer-shareholder receives the time-value savings occasioned by the delay in recognizing the income represented by the cash available from the interest-free loans.

The IRS and Excessive Compensation: How Might They Respond?

The IRS might adopt a stance reversing its historic arguments against unreasonable compensation, but taxpayers have a rich source of prior case law and administrative rulings to draw upon in preparing a defensible position. Moreover, the IRS is likely to find that it would be economically disadvantaged were it to establish a new rationale that could be used to justify higher officer-shareholder compensation payments by a huge number of small corporations. In the authors’ opinion, the IRS is unlikely to fight to characterize these payments as reasonable compensation.

The IRS might argue, however, that the annual loans represent compensation that was improperly deferred under the deferred compensation rules for failure to make a timely election, and should have been included in the year in which it was earned. This, however, would require some evidence that the corporation is obligated to pay the officer-shareholder the sum lent, and that would be in direct contravention of the documentation that should be created to document the loan. There may well be an informal understanding of the intent to forgive the loans at some future date. If, however, the officer-shareholder is legally obligated to repay the interest-free loans without a guarantee that they will be forgiven, it is unlikely that the IRS could sustain the contention that the loans were compensation when made.
With regard to dividends, such payments are required under state law to be pro rata. The authors know of no cases in which payments of compensation deemed to be dividends by federal tax law have been held to violate such state law provisions. It does seem likely that unhappy shareholders, especially in closely held corporations, could bring suit to require corresponding payouts to themselves, were they to learn of uncompensated use of corporate property. If successful, such litigation could force corporations to pay out dividends to other shareholders in cases where officers received deemed dividends. The deemed dividend is determined under federal tax law and certainly would not be considered determinative for purposes of state law; however, such a determination could well establish a presumptive cause of action, and one would expect that such a suit would be seriously considered in some states. In many large publicly held corporations, the officers own a relatively small percentage of the stock, the value of which is generally dwarfed by the deemed dividends. Requiring a pro rata distribution to other shareholders, if feasible at all, would probably require the liquidation of the corporation.

Planning Implications

These examples show that it may be possible to “launder” interest income using the interest-free or reduced-rate loan provisions of section 7872. For corporations in the low-initial-rate brackets or for corporations with NOLs, the tax savings can present interesting possibilities. If the NOL were due to expire, the tax savings could be even more attractive, although such expirations are somewhat rare.

Other planning strategies exist. If a corporation borrows to fund the interest-free loan to an officer-shareholder, it is possible to bleed the corporation of assets. Moreover, that can be accomplished at no tax cost to the shareholder and no net tax cost to the corporation. Where compensation in excess of $1 million cannot be deducted by reason of the IRC section 162(m) limitations, it is possible for the corporation to achieve both deferral and a lower tax rate for the officer-shareholder at no additional cost to the corporation.

The opportunities to launder interest income may be one of the arguments that will be made against extending the lower tax rate on dividends, which is due to sunset after 2008. The economic-stimulus argument for reducing or eliminating the tax on dividends to encourage distribution of earnings and the redeployment of capital to emerging and more rapidly growing areas of the economy is, in the authors’ opinion, much more important. But the outcome of the political debate is probably less dependent on economic analysis than it is on the electoral interests of the political party in control at the time.