Tax Tail Wags The Dog: Misunderstanding Imputed Interest

Explore:  Gift Tax Income Taxes

Tax professionals (accountants and lawyers) have an unfortunate tendency to transmute tax rules into general legal rules. Worse yet is the tendency of tax professionals to spread the gospel, as it were, and create legions of followers who labor under mistaken notions of what is permitted or prohibited at a business level.

Take the case of an employer who wishes to make an interest-free loan to an employee.  Internal Revenue Code Section 7872 calls generally for the imputation of interest which will be taxable compensation to the employee and deductible to the employer.

Over the years we have heard many a tax advisor telling his client (the employer) that the IRS requires that the employer charge a minimum rate of interest on the loan — as if there is a law that requires an employer to charge an employee interest on a loan. There is no such law!

I have heard many a non-tax professional (and sometimes clients) say that the law requires that interest be charged on a gift loan, an employee loan or an installment sale. No doubt he or she heard that from a tax professional who failed to differentiate tax rules from legal rules.

The fact that one must impute income and expense for tax purposes should have no bearing on the client’s business decision whether to make an interest free loan to an employee. The fact that one might have to calculate OID on an installment note does not mean that a minimum rate of interest must be charged. Advice to the contrary is classic "tax tail wagging the dog."

Having challenged fellow tax professionals about this from time to time, the response I often get is that having the employee pay the minimum rate of interest prescribed in the AFR tables avoids the “complexity” of calculating the imputed interest. Come on! There is little more complexity to calculating imputed interest than in calculating actual interest were the employer to charge it.

I will often get the response that the employee will not want to pick up imputed interest in income. As if the employee would rather pay a dollar of interest than be taxed on it? This excuse for misguided advice will not fly.

And the refrain of last resort I hear is “we do not want to put red flags on the tax return.”  As if showing imputed compensation expense is somehow abusive? Not at all. The Internal Revenue Code mandates imputation when employers choose to be generous and not charge interest on an employee loan. There is no abuse.

A similar situation arises in connection with interest-free loans to family members or friends.  Often a tax advisor will encourage the client to charge interest when none is intended, to avoid the imputation of interest which could be treated as a gift. Is that really advice? Or when a tax advisor tells a client to charge interest on deferred selling price when the bargained for deal was interest-free. Telling a client to retrade a deal in order to avoid a tax calculation is not tax advice.

Rarely is the right answer for the tax professional to encourage a client to alter his intentions and charge interest where none was ever intended. A “fix” is not a fix when the client’s business objectives are fundamentally altered.

Seeing all the world through a tax lens allows us to create considerable value for our clients. But we must remain on guard not to confuse tax rules with rules of law.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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