Revenue Ruling 83-42: Below-Market Shareholder Loans

Internal Revenue Code (IRC) Section 7872 addresses the tax implications of loans made at below-market interest rates. The rules ensure the time value of money is properly accounted for. The primary focus is on specific lending relationships where the interest rate charged is less than the market rate, creating a financial benefit for the borrower that the Internal Revenue Service (IRS) views as a form of taxable transfer. This framework prevents the use of interest-free or low-interest loans as a method to shift income or provide compensation without corresponding tax consequences.

Determining Applicability

The rules are triggered by the specific relationship between the lender and the borrower. A primary scenario involves a corporation making a loan to one of its shareholders. For these regulations to apply, the loan must either be interest-free or carry an interest rate lower than the federally mandated minimum. This direct corporation-to-shareholder link is where the loan is presumed to be a benefit derived from the shareholder’s equity position.

The determination does not depend on the loan’s purpose or the corporation’s history of paying dividends. The existence of a below-market loan between a corporation and its shareholder is sufficient to bring the transaction under these rules.

Calculating the Shareholder’s Taxable Income

When a shareholder receives a below-market loan from their corporation, they are considered to have received taxable income. The amount of this income is “foregone interest.” This is the difference between the interest that would have been paid using a statutory rate set by the government and the interest that was actually paid.

The specific statutory rate used, known as the Applicable Federal Rate (AFR), depends on the loan’s structure. For a term loan, the AFR is determined on the date the loan is made. For a demand loan, the calculation is different. To simplify the process for demand loans with a fixed principal amount outstanding for an entire calendar year, the IRS publishes a single “blended annual rate” each year.

The calculated foregone interest is treated as a distribution from the corporation to the shareholder. This amount is typically classified as a dividend, to the extent of the corporation’s earnings and profits. The shareholder must report this imputed amount as dividend income on their personal tax return for the year, even though no cash was actually received for this specific interest amount.

Tax Treatment for the Corporation

The tax consequences for the corporation are structured as a two-part deemed transaction. First, the corporation is treated as if it received an interest payment from the shareholder. This imputed interest income is equal to the foregone interest amount. The corporation must include this amount in its gross income for the tax year.

Simultaneously, the corporation is deemed to have paid the same amount back to the shareholder as a dividend distribution. While the corporation must recognize the imputed interest as income, the corresponding deemed dividend payment is not tax-deductible. This treatment prevents the corporation from offsetting the recognized interest income, as dividend payments are distributions of profit and not deductible business expenses.