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George F. Bearup, J.D. Senior Legal Trust Advisor

12-Jun-19

Below Market Interest Rates and Their Tax Treatment

Take-Away: A below market interest rate charged on a loan, or a note given in exchange for the acquisition of an asset, is governed by the Tax Code. The Tax Code imposes some unusual assumptions for both the lender and the borrower.

Background:  IRC 7872 went into effect in 1984. It provides that if a below-market interest rate is charged on a loan/note,  an implied gift results. Consequently, using the correct interest rate is important in intra-family loans, or in the sale of an appreciating asset to a grantor trust, often called a sale to an intentionally defective grantor trust or IDGT, where the trustee gives a promissory note in exchange for the acquired asset.

IRC 7872: This Tax Code section applies to any transaction that: (i) is a bona fide loan; (ii) which is below market; (iii) which falls within one of four categories of below-market loans; and (iv) which does not qualify for one of several statutory exceptions.

  • Four Loan Categories: The four categories are loans: (a) from a donor to a donee; (b) from an employer to an employee; (c) from a corporation to a shareholder; and (d) with interest arrangements made for tax avoidance purposes. [IRC 7872(c).]
  • Loan Re-categorization: A below-market loan is re-characterized into a two-step transaction.
  • Lender: The lender is treated as having transferred on the last day of the calendar year an amount equal to the forgone interest, which is the prevailing federal rate of interest less the loan’s actual interest rate.
  • Borrower: The borrower, either an individual in an intra-family loan situation, or a trust in the sale to an IDGT, is treated as re-transferring that amount back to the lender as imputed interest income.

Frazee:  Frazee v. Commissioner, 98 Tax Court 554 (1992) is an example of how this Tax Code section is applied to result in a taxable gift by the lender.

Facts: The parents were growers of flower bulbs, sold internationally. Wanting to retire, the parents decided to transfer their business to their children. The parents transferred real estate, valued at $985,000, in exchange for a promissory note from their children with a principal balance of $380,000. The note carried interest a 7% a year, secured by a mortgage. The note provided for graduated repayments with quarter-annual installment payments. The parents filed a gift tax return and reported a gift of $605,000 with regard to the real estate. The Tax Court later determined the real estate to be worth $1.0 million, with $950,000 allocated to the land and $50,00 to improvements to the land. Consequently, the value of that taxable gift was adjusted in the Tax Court.

Issue: While the gift of the real estate was reported and a gift tax assessed on the difference in value of the real estate, also challenged in the Tax Court was an additional taxable gift [IRC 2501] imposed because the promissory note bore a below-market interest rate.

Decision: The Tax Court found that the difference in interest rate charged on the note versus the prevailing interest rates resulting in another taxable gift. “When a transfer is not arm’s length and free of donative intent, a promissory note received by the donor constitutes consideration only to the extent of its fair market value. The difference between the amount lent and the fair market value of the promissory note constitutes an additional gift to the donee. Therefore, a below-market loan will be treated as a gift loan unless it is a transfer made in the ordinary course of business, that is, unless it is a transaction which is bona fide, at arm’s length, and free of donative intent.”

“Under section 7872, a below-market loan is re-characterized as an arm’s-length transaction in which the lender is treated as transferring to the borrower on the date the loan is made the excess of the issue price of the loan over the present value of all the principal and interest payments due under the loan. The transfer by the lender to the borrower is deemed a gift. By enacting section7872, Congress indicated that virtually all gift transactions involving the transfer of money or property would be valued using the current applicable Federal rate Sec. 7872(f)(2)(B). In doing so, Congress displaced the traditional fair market methodology of valuation of below-market loans by substituting a discounting methodology.”

The Tax Court held that the IRC 7872 applicable interest rate (the AFR) and not IRC 483(e) six-percent interest reate was controlling for federal gift tax purposes. Consequently, because the intra-family sale of real propoety was not a bona fide arms-length transaction that was free from any donative intent, the exess of the face amount of a note bearing a 7% interest over its recomputed present value, using the AFR for long-term loans, constituted a gift of interest.