Considerations for Owners Lending Money to Their Company: Charging Interest
Jeff Storch | 01.29.20
Often, owners of a business lend money to their company, whether for short-term needs or for longer-term purposes. Too often, owners may not take the time to document the loan or take other steps to protect the owner as lender.
This is the second of three posts discussing steps owners can take to protect themselves: discussing the requirement to charge minimum interest.
Generally, a minimum amount of interest must be charged on a loan, or else the IRS may impute interest. The IRS characterizes a “below-market loan” as one where the interest rate charged is lower than the IRS’s current applicable federal rate (AFR). On below-market loans, the IRS can impute the amount of interest that would be payable if interest accrued on the loan at the AFR (less any interest actually paid).
A lender on a below-market loan will generally find that the foregone interest will be treated and must be reported as interest income to the lender. In certain circumstances the borrower may be able to deduct the foregoing interest. The borrower also may be required to file and send a Form 1099-INT each year or face penalties.
The AFR varies depending on the length of the loan, with different rates for short-term (3 years or less), mid-term (more than three years up to nine years), long-term (more than nine years), and demand loans. The IRS updates the various AFRs monthly. The date of the loan determines which month’s AFR to use.
Note that different rules apply to below-market gift loans, demand loans, and term loans. There are also certain qualified exceptions for loans for $10,000 or less, loans to continuing care facilities, loans without significant tax effect, and gift loans of $100,000 or less where the borrower’s net investment income is less than $1,000. However, it is generally prudent to charge actual interest at or above the current AFR.
Consequently, when drafting the promissory note for your loan to your company (see prior article), you will want to charge at least the required minimum amount of interest. (And do not forget to report interest paid on Form 1099-INT.)
Watch for our final post in this series, discussing obtaining security for your loan.
DISCLAIMER: The information provided is for general informational purposes only. This post is not updated to account for changes in the law and should not be considered tax or legal advice. This article is not intended to create an attorney-client relationship. You should consult with legal and/or financial advisors for legal and tax advice tailored to your specific circumstances.