1. Interest-Free and Below Market Rate Loans Chapter 37 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company1 There are few tax advantages to an interest-free or below market rate loan due to the denial of all personal interest deductions, and the limitation of investment interest deductions to investment income Most of these loans are between –A corporation and non-shareholder employee –Parent to child or other family member Economic advantage lies in the borrower’s ability to use either the funds or the interest from the funds Interest-Free And Below Market Rate Loans

2. Interest-Free and Below Market Rate Loans Chapter 37 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company2 To reduce the estate of the lender by limiting the future growth in the value of the assets To shift economic wealth to the borrower As a corporate fringe benefit to allow an employee to –Purchase a home –Provide for a child’s education –Purchase stock of the employer-corporation –Pay life insurance premiums –Pay medical bills When Is Use Of Such A Loan Appropriate?

3. Interest-Free and Below Market Rate Loans Chapter 37 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company3 Transfer of income through interest-free or below market rate loans can be used to –Support parents –Provide support for children in school –Help family members purchase a home or business When Is Use Of Such A Loan Appropriate?

4. Interest-Free and Below Market Rate Loans Chapter 37 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company4 Transaction must constitute a bona fide debt, preferably in writing If parties maintain books or records of account, the debt should be entered There should be a provision in the debt instrument expressly precluding interest, or stating the below market rate to be charged What Are The Requirements?

5. Interest-Free and Below Market Rate Loans Chapter 37 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company5 To assure a loan from a corporation to an employee is not construed as compensation income the following requirements must be met: –Arrangement must constitute a bona fide debt Preferably in writing Containing a reasonable repayment schedule or a note payable on demand –A demonstrated intent to repay must be evidenced by an agreement between the parties, otherwise the IRS could claim the loan is a disguised compensation –Amount of the loan must be reasonable in relation to the salary of the employee What Are The Requirements?

6. Interest-Free and Below Market Rate Loans Chapter 37 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company6 Avoid situations where the corporation borrows money to make interest-free loans to shareholders What Are The Requirements?

7. Interest-Free and Below Market Rate Loans Chapter 37 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company7 Good Example –Mom advances her daughter a $150,000 interest-free loan to enable her daughter to purchase a new home Note: Interest income will be imputed to mom How Is It Done?

8. Interest-Free and Below Market Rate Loans Chapter 37 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company8 Bad Example –Rich, Tony, and Larry each own 1/3 of their family business Business creates interest-free loan agreements with each of them In order to make the loans, the business had to have the company’s suppliers extend substantial amounts of credit Rich, Tony, and Larry personally guarantee the obligations to the business suppliers Every time the business pays interest to the creditors it is acting like an agent for Rich, Tony, and Larry, and in essence discharging the personal obligations of the shareholders To the extent actual payments are made, Rich, Tony, and Larry are deemed to have received dividend income and made an interest payment How Is It Done?

9. Interest-Free and Below Market Rate Loans Chapter 37 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company9 Loans with no interest or below market rate interest are re-characterized for tax purposes as loans bearing a market rate of interest accompanied by a payment or payments of interest from lender to borrower, and are subject to general rules for interest deductions “Phantom payments” are the difference between what should have been charged and what was in fact charged for the use of the money lent Tax Implications

10. Interest-Free and Below Market Rate Loans Chapter 37 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company10 Phantom payments will be re-characterized as: –Compensation from a business to an employee –Dividend from corporation to its shareholder –Gift from shareholders of corporation to borrower –Gift from parent to child Gifts of phantom payments may be subject to gift tax Tax Implications

11. Interest-Free and Below Market Rate Loans Chapter 37 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company11 Issues In Community Property States State gift taxes on interspousal gifts : –If money lent is separate property but the note is made in favor of both spouses –If money lent is community property and the demand note only favors one spouse –Money lent to one spouse was used to purchase assets in the names of both spouses –Use of community funds or separate property of a non-borrowing spouse to repay the separate loan of the borrowing spouse Avoid a gift in this instance, by the borrower spouse giving the non- borrowing spouse or the community a note for the amount of the funds used to repay the separate obligation