Revenue Ruling 83-35 and Section 482 Loan Rules

When related businesses, such as two companies owned by the same person, engage in transactions, the Internal Revenue Service (IRS) pays close attention. A common example is an interest-free loan from one entity to the other. The IRS can adjust the income of these businesses to reflect what the transaction would have looked like if they were unrelated. The enactment of Section 7872 of the Internal Revenue Code in 1984 established the modern framework for how the IRS treats below-market and interest-free loans.

The Arm’s Length Standard and Section 482

Section 482 of the Internal Revenue Code grants the IRS authority to reallocate income, deductions, credits, or allowances among organizations that are owned or controlled by the same interests. The purpose of Section 482 is to ensure that taxpayers clearly reflect their income and to prevent the use of related entities to artificially shift profits and avoid taxes. This allows the IRS to adjust the financial results of controlled transactions to what they would have been if the parties were not related.

This authority is guided by the “arm’s length standard,” which is the benchmark for evaluating transactions between related parties. It dictates that the terms and pricing of a transaction between controlled entities should be the same as they would have been between two independent parties under similar circumstances. For example, when one controlled company lends money to another, the arm’s length standard generally requires that the loan carry an interest rate that an independent lender would have charged for a similar loan.

Modern Rules for Interest-Free Loans: Section 7872

The tax treatment of interest-free and below-market loans was changed by the introduction of Section 7872 to the Internal Revenue Code in 1984. This section provides specific rules that require interest to be imputed on such loans, regardless of whether the borrower generated income with the loan proceeds.

Under Section 7872, if a loan between related parties carries an interest rate below the applicable federal rate, the law treats the “foregone” interest as if it were paid. This foregone interest is treated as a transfer from the lender to the borrower, and then retransferred from the borrower back to the lender as an interest payment.

The result is that the lender must typically recognize the imputed interest as taxable income. The borrower, in turn, is treated as having paid that interest, which may be deductible depending on how the loan proceeds were used. While certain exceptions and minimum thresholds can apply, Section 7872 ensures that the tax code reflects the economic reality of the loan by imputing interest at a market rate.