We are going to take a side trip from our recent discussions surrounding the wonderful world of ILITs in order to address one of the more insidious bamboozles the IRS pulls, imputed interest.
As we all know, family members mooch. I have been on both the giving and the receiving end of the less than enthusiastic family loan. What nobody told me was that in addition to lending money, the IRS might very well force me to recognize interest income on that loan regardless of whether I receive it or not.
Under Internal Revenue Code 7872, the IRS requires any lender to recognize interest on a “below market” or “gift” loan. Basically, if you lend someone money and do not charge adequate interest, the IRS is going to impute adequate interest to you as income.
There are de minimus exceptions that have other exceptions within exceptions, and all of those can be perused at your leisure in your tax code. We are in the business of pointing simply to the inherent unfairness (not really) of the tax code, and not the minor exceptions the IRS sparingly parses out.
Now, there are two types of loans, the both aptly named term loan and demand loan. Each has its own unique set of rules regarding imputed interest. This week’s blog will divulge the secrets of the demand loan.
A demand loan is a loan with no fixed term for repayment. When no fixed term for repayment exists, foregone interest must be calculated annually. For example:
Assume A lends 100,000 to B interest free, with the balance payable upon demand. At the end of year one, the IRS would impute interest income to A. Absent a stated interest rate, the IRS imputes the applicable federal rate to any gift or demand loans in order to determine income required to be recognized.
What is the Applicable Federal Rate? Basically, it is the current market interest rate as determined by a statutory formula that analyzes interest rates on Federal obligations of appropriate maturity. Each month, the IRS publishes AFRs for short-term, mid-term and long-term loans. Imputed interest computations for a demand loan under Sec. 7872(f)(2) are based on the blended short-term rate in effect for the period for which the amount of forgone interest is being determined. The blended short-term rate is basically an average determined by taking ½ * January’s published short-term AFR + ½ * July’s published short-term AFR.
Given the current economic climate and the Feds attempts at curtailing inflation, short term AFRs are at historic lows. However, blended short term AFRs have been as high as 9% and are historically around 3-5%, which means in our example above, A could have imputed interest income of $5,000.00. Let’s assume that A is in the highest federal tax bracket. This means that A has to come out of pocket with $1,750.00 to pay taxes on income he never received.
Brian J. Baker