Interest-Free Loans to Shareholders

IRC section 7872 was enacted to eliminate the tax advantages of making interest-free or below-market-rate loans by treating such a loan as economically equivalent to a loan bearing interest at an imputed rate coupled with a payment by the lender to the borrower sufficient to fund the payment of interest by the borrower. The recently enacted equivalent treatment of dividends and long-term capital gains changes the tax consequences of such loans when made to corporate shareholders. This disparity occasions new corporate and personal planning opportunities and new concerns for the IRS. The authors explore a number of permutations of personal and corporate tax circumstances and analyze the tax savings or costs associated with each strategy and discuss the tax policy implications of recent and future legislation in this area. The economic-stimulus argument for reducing or eliminating the tax on dividends to encourage distribution of earnings and the redeployment of capital to emerging and more rapidly growing areas of the economy, in the author's opinion, is much more important.