Banks recently lowered their interest rates nationwide. But you might do even better than a low-interest bank loan.
Strategy: Arrange a no-interest loan from your company. This is perfectly legal, but it comes with some drawbacks. First, you’re subject to tax on this benefit. Second, if you’re not careful, your company could be socked with a tax bill for “phantom income” it never received.
Establish in the corporate minutes that the loan is being made for compensatory reasons. Although you’ll still owe tax on the compensation, at least your company will see offsetting deductions.
Here’s the whole story: When a no-interest or a below-market loan is made by a company to a shareholder, the “imputed interest rules” take effect. Under this provision, your company is treated as paying you an amount equal to the interest that wasn’t charged. In turn, you’re treated as using this payment to pay interest on the loan.
Example: If the payment is deemed compensation, the additional income is reported on your W-2. On the other hand, if you’re receiving the interest-free loan because you’re a shareholder, it’s taxed to you as a dividend. Either way, the company is charged with receiving taxable interest income, even if you’re not actually paying any interest on the loan.
Key difference: Your company can write off payments treated as compensation just like wages paid to other employees. But dividends aren’t deductible by the company. And, if you’re a 5%-or-more shareholder, the payment is treated as a dividend unless you can provide “clear and convincing evidence”that the transaction is compensatory in nature.
In order to establish that the payment represents compensation, spell out the loan details in the corporate minutes. Start by explaining that the loan is being made for compensatory reasons and list the valuable services you provide to the company. Show that your company has a policy of providing compensatory loans by offering the same type of loan to key employees who are not shareholders. It will also help if your company can maintain its traditional dividend-paying history while the loan is outstanding.
Note that the timing of the income and the deductions under the imputed interest rules depend on whether the loan is a “term” loan or a “demand” loan.
With a term loan, you receive an up-front payment and repay the loan over a specified term. Therefore, your company receives a big current deduction while the interest income is spread out over a period of years.
With a demand loan, both the payments and the income are determined on an annual basis. Thus, your more from a term loan but at your tax expense.
Are you entitled to any offsetting deductions? It depends on the use of the loan proceeds. If the money is used for personal purposes, you get no deduction. However, if the deemed interest qualifies as deductible investment interest or mortgage interest, you may offset all or part of the taxable compensation. In other words, if you handle things right, you can effectively create a tax-free fringe benefit for yourself.
Tip: The imputed interest rules don’t apply to shareholder loans of less than $10,000, so long as tax avoidance is not the transaction’s primary motive.
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