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Phantom Income – Below-Market Loans and Imputed Interest

There are many situations where a low-interest or zero-interest loan may make sense personally or financially—including to a family business looking to expand or get through a challenging season, to your family or friends facing hardship or opportunity, or from your businesses to members or employees as a perk. While you may not care about the foregone interest that you could have made from a below-market loan, the IRS probably does.

A below-market loan is a loan where the interest rate charged is lower than the current applicable federal rate (AFR). Simplified, foregone interest is the amount of interest that would be payable if interest accrued on the loan at the applicable federal rate, 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 may also be required to file and send a 1099-INT each year or face penalties.

For example, if in March of this year you make a zero-interest one-year loan of $100,000 to your limited liability company, the foregone interest, and potentially imputed interest income, is $1,065, based on the March 2018 short term AFR of 1.96%, compounded annually. While the reasons for the loan may outweigh the imputation of that interest income, you still must be aware of and follow IRS rules for reporting.

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.   

More details on below-market loan rules can be found in IRS Publication 535, Business Expenses, and Publication 550, Investment Income and Expenses. Applicable federal rates are updated monthly and an Index of Applicable Federal Rates (AFR) Rulings for each month may be found on the IRS website.

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.

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