In 2023 interest rates rose to record highs, and unlike President Donald Trump, it’s unlikely your dad gave you a “small loan of a million dollars” to start your business (I bet that he got a great interest rate too). However, perhaps friends or family loaned you a much smaller amount of money to get your business off the ground. If they’ll loan you the money at a below-market interest rate, that’s a deal! So, what are the tax consequences of a below-market loan?
This blog will discuss how to determine whether your loan is below-market rate, identify whether the loan is a gift, and determine the tax consequences of a below-market loan.
The Applicable Federal Rate.
First, let’s figure out if your loan is considered a below-market loan. Each month, the Internal Revenue Service (“IRS”) publishes the applicable federal rate (“AFR”). For your purposes, the IRS considers anything below the AFR “low interest,” this includes an interest rate of zero percent. If your interest rate is above the AFR the loan is not considered a gift.
Gift Loans.
Next, it’s important to determine whether the low or interest-free loan is a gift. The IRS considers a transfer of property between two taxpayers a gift if the transfer was made with detached and disinterested generosity. If your friends or family give you a loan to start your business because they love you so much, the loan is likely a gift.
However, if the loan was made with the understanding that sometime down the road the lender would get something of value in return, then the IRS will likely view the transaction as not a gift. Thus, the takeaway is that if you receive a low or interest-free loan from family or friends, no strings should be attached.
Additionally, all loans should be demand loans because this prevents an unexpected tax bill for the borrower. Demand loans are those that lack a fixed period of repayment, and the lender can ask for repayment at any time.
The Borrower’s Tax Consequences.
Great! Now you’ve got your below-market demand loan, it’s time to determine the tax consequences for both you and the lender. The good news is that loans are not income to the borrower. Thus, no tax consequences immediately occur for the borrower.
What about when you pay the loan back? I’m glad you asked because there is more good news. If the loan was interest-free, you receive no deductions because there was no additional cost. If the loan had a small amount of interest, let’s say 1%, then any interest you pay the lender might be deductible for your business.
A taxpayer can take a deduction when certain conditions are met. First, the expenditure must be one that can be used up in less than one year. Generally, interest meets this requirement because it is calculated annually. Second, the expenditure must be used in a trade or business. This should be easily met because you are using the loan for your business. Third, the expense must be ordinary and necessary for your business. Generally, paying interest on a loan is an ordinary and necessary business expense. Finally, the expense must be for business not personal reasons. Only using the loan for business expenses should satisfy this requirement. If you meet all the requirements, you should be able to deduct the below-market interest as a business expense.
The Lender’s Tax Consequences.
For the lender, the tax consequences are slightly different. No tax consequences occur for the lender when they lend you the money.
However, tax consequences may occur when the borrower repays the lender. Essentially, the IRS discounts the lender’s loan by the AFR. The difference between the actual amount repaid and the discounted loan is interest income to the lender. Thus, it will be taxed at the lender’s ordinary tax rate. Importantly, this has no effect on the deduction that the borrower may qualify for.
Beware of Exceptions.
Two major exceptions to these rules exist.
First, if the loan is equal to or less than $10,000, neither the lender nor the borrower has any tax consequences. Only two requirements exist. First, the borrower cannot use the money to purchase income-producing assets, like real estate, bonds, or stocks. Second, the principal reason for the loan must not be tax avoidance. Generally, this exception is an excellent way for the lender to avoid adverse tax consequences.
The second exception is slightly more complicated. If the loan is $100,000 or less, the borrower can use the loan to purchase income-producing property only if the net income generated by the property is less than the AFR. If the net income is under $1,000, the IRS treats it as zero dollars. Again, the principal reason for the transaction cannot be tax avoidance. Generally, this exception to buying income-producing property makes little sense because it results in the lender losing money.
The Takeaway for Entrepreneurs.
All in all, securing one or more below-market demand loans of $10,000 or less is likely the simplest way for you to secure business financing from your friends or family because the transaction will likely result in no tax consequences for everyone. Also, below-market loans are an awesome way to buy real property that produces no income for your business because bank loans are at record highs.
Now that you’ve learned all about below-market loans, it is time to get your “small loan of a million dollars” to get your business off the ground! Don’t forget, it is always a prudent idea to consult a tax attorney before engaging in a complicated transfer of property.
Sources
IRC § 7872
Examples & Explanations: Federal Income Tax, by Joseph Bankman, Thomas D. Griffith, & Katherine Pratt.
Com. v. Duberstein, 363 U.S. 278 (1960).
https://www.irs.gov/applicable-federal-rates
https://www.businessinsider.com/donald-trump-small-million-dollar-loan?op=1
https://www.msn.com/en-us/money/personalfinance/houstonians-are-carrying-more-and-more-credit-card-debt-a-tight-spot-as-interest-rates-hit-record-high/ar-AA1a3SbQ
Images
https://www.pexels.com/photo/hands-holding-a-10-dollar-bill-4968382/
https://www.pexels.com/photo/person-s-holds-brown-gift-box-842876/
https://www.pexels.com/photo/crop-anonymous-person-calculating-profit-on-smartphone-calculator-near-banknotes-4386321/
https://www.pexels.com/photo/light-bulb-577514/
https://www.pexels.com/photo/cutout-paper-composition-of-yellow-signboard-with-exclamation-mark-5849597/
