Reevaluate Shareholder Loans

With all the angst about the economy, high gasoline prices, and the lousy real estate environment, you may not have noticed that most interest rates are near historically low levels. This includes the IRS-approved applicable federal rates (AFRs). In the context of loans from corporations to their shareholders, this is favorable news. Here’s why: When a corporation makes a loan to a shareholder, the complicated below-market interest rules apply unless (a) the loan charges an adequate rate of interest (determined by comparison with the applicable AFR) or (b) all loans between the corporation and the shareholder aggregate to the de minimis amount of $10,000 or less. This is extremely important because the IRS can impute additional interest on a loan when the interest rate is below the AFR and then characterize that additional interest as either taxable compensation or a taxable, but nondeductible, dividend.

For the below-market interest rules, adequate rate of interest means a rate equal to or higher than the AFR. In other words, when the corporation charges at least the AFR on a shareholder loan, the nasty below-market interest rules are avoided. So, this is usually the tax-smart way to go.

Since the current AFRs are low, now is a great time to take a fresh look at the idea of making additional low-interest loans from corporations to shareholders, replacing existing higher-interest shareholder loans with new ones that charge lower rates, or converting demand loans to term loans to lock in the low rates.

Once the AFR is determined, it continues to apply over the life of the loan, regardless of how interest rates may fluctuate. The exception is for a demand loan where the AFR is not fixed at the time the loan is made. Instead, the AFR is calculated using an annual blended rate that takes monthly AFR changes into account. Since demand loans don’t lock in today’s low AFRs, term loans are generally preferred—unless you believe future AFRs will be even lower.

This topic might seem rather technical and complicated, but a little time and effort now will help avoid future problems, particularly with the IRS.