Employers who offer special rate loans to employees—either directly or through a third-party lender—may need to consider the effect that the rising Applicable Federal Rate (AFR) will have on such loans. Loans with rates lower than AFR may create phantom income to the employee.
Many employers—especially financial institutions—provide their employees access to credit products at discounted interest rates. These employee loans can provide great benefits to employees, but employers must carefully consider all applicable tax requirements related to employee loans. While it may be tempting to offer an interest-free or incredibly low interest rate loan to employees, the below-market loan rules may create some unintended consequences for such loans.
A loan is below-market if it bears interest at a rate less than the AFR. However, these rules only apply to certain categories of loans, including the category of “compensation-related loans.” Compensation-related loans are any below-market loans made in connection with the performance of service, directly or indirectly, between an employer and an employee or independent contractor. An employer, however, cannot circumvent these rules by hiring an unrelated third party to lend to its employees. The third-party lender will likely be treated as an agent of the employer, so the loans will still be compensation-related loans.
However, there are two exceptions to the below-market loan rules. First, there is an exception for de minimis loans. The rules don’t apply if the aggregate outstanding amount of loans between the employee and employer does not exceed $10,000. Second, there is an exception from some loans made to aid employees in purchasing principal residences in connection with moves to new work locations.
The major consequence of making a below-market loan to an employee is that the employee will have phantom income. When a below-market loan is made, the employer is treated as having paid compensation to the employee. This deemed payment of compensation is (1) a deduction for the employer and (2) an income inclusion for the employee. The amount of the compensation that is deemed to be paid is the difference between the interest that would have been paid using AFR and the interest at the rate used for the loan.
It is important to determine when a loan is “made” for purposes of applying the below-market loan rules. For example, with regard to revolving or installment loans, each extension, credit, or transfer of money by a lender to a borrower is treated as a separate loan. This means that below-market status is not just determined when a loan is issued, but determined every time there is an advance under that loan. This could mean that today’s advances under a revolving loan with a historically low interest rate could be below-market loans if AFR continues to rise. Employers should make sure that interest rates on their employee-loans are flexible enough to adjust to the rising AFR.
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