At one time, a shareholder could borrow money from his corporation interest‑free without recognizing income. That changed with the enactment of § 7872 in 1984. Now, below‑market loans between corporations and shareholders are recharacterized – the “foregone interest” is treated as a transfer from the lender to the borrower and then back.
How does it work? If the loan is a demand loan, the foregone interest is treated as paid by the corporation to the shareholder (a dividend) and then paid by the shareholder to the corporation (which may be treated as a contribution to capital or additional interest). If the loan is a term loan, the amount borrowed minus the present value of repayments is treated as a transfer from the lender to the borrower – again, a dividend.
The rule applies if the aggregate amount of corporation‑shareholder loans exceeds $10,000, unless tax avoidance is not a principal purpose. § 7872(c)(3). In KTA‑Tator, Inc. v. Comm’r, 108 T.C. 100 (1997), the Tax Court explained that the deemed transfer from the corporation to the shareholder is a dividend, and the corporation has to include the foregone interest in income but gets no deduction for the deemed dividend.
So what’s the practical effect? If you borrow money from your corporation, you must pay at least the Applicable Federal Rate (AFR) in interest. Otherwise, you’ll be deemed to have received a dividend equal to the interest you should have paid. And the corporation will have taxable interest income without a corresponding interest deduction. It’s a lose‑lose. So always charge a market rate of interest on shareholder loans.This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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