Preventing Imputed Interest in Loan Transactions

Question:  As part of the upcoming sale of my business, I will be receiving a promissory note with no payments to be made until the note’s five-year maturity date.  If interest accrues at the IRS rate of interest, will I be subject to imputed interest?

 Answer:  The Internal Revenue Code contains provisions imputing interest in various types of transactions.  The imputed interest rules reclassify as interest amounts which are otherwise designated in transactional documents as principal.  Where interest is imputed in a business transaction, both the lender and the borrower face differing tax treatment than the transaction documents otherwise call for.   

The most common imputation of interest rules involve loans which carry below-market rates of interest or no interest at all. With limited exceptions, the Code requires that appropriate interest is charged in borrowing transactions. If, for example, a borrower issues a loan and fails to charge any interest or charges interest at a rate less than the interest rates the IRS regularly publishes, interest will be imputed in the transaction, the treatment of which will depend on the nature of the transaction. The rules are designed to prevent lenders and borrowers from failing to report appropriate amounts of interest income and expense.        

Even in circumstances where the below-market interest rates do not apply, interest can be imputed if interest payments are not required to be paid on a regular basis. Where a debt instrument is issued and the amount due upon maturity of the loan (known as the stated redemption price at maturity) exceeds the amount borrowed (known as the issue price), the difference (known as original issue discount or “OID”), will be treated as interest.  To determine the stated redemption price at maturity, all amounts payable under the debt instrument are taken into account, excluding interest which is payable at periodic intervals of one year or less.  Essentially both the lender and the borrower must report interest each year during the term of the loan, disregarding the fact that no interest is actually paid.           

You indicate that the debt instrument you will be receiving carries an adequate rate of interest which will permit you to avoid having to treat the loan as a below-market loan.  However, by virtue of the debt instrument postponing all interest payments until the five-year maturity date, the loan carries OID which must be reported by you and the borrower on an annual basis.  As the lender, this will create phantom income as you will be reporting each year as ordinary income the interest which is imputed without the accompanying cash payment to you to cover the tax liability.          

As a planning suggestion, you can negotiate with the borrower for annual interest payments to be made at an appropriate IRS rate of interest.  You might even accept a relatively low-interest rate so long as the rate equals or exceeds the IRS rate.  Prudent planning suggests that you avoid being in the position where you must report phantom income in this or any other business transaction. In most cases, the consequences of imputed interest only arise where proper tax planning is not undertaken.

 

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want to be answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.