Category: Corporations; Miscellaneous
Subject: Below Market Loans
Title: Below Market Loans Between Brother-Sister Corporations, Imputed Interest, Possible Recharacterization of Loan
IRC Sections: 7872
Filename: 1234.html
Date Produced: 05/95

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Background
Individual taxpayer (TP) owns 100% of the stock of Corporation A, a C corporation, and 100% of the stock of Corporation B, an S corporation. Corporation B owes $35,000 to Corporation A as a result of a direct loan of money between the two companies.

Issues
1. Is Corporation A compelled to either charge or impute interest on the loan to Corporation B?

2. If not, is there any reason to do so anyway?

Answers
1. Corporation A is not compelled by statute or regulation to charge or alternatively to impute interest on the loan to Corporation B.

2. TP and Corporations A and B are exposing themselves to possible adverse tax consequences if adequate interest is not charged and other precautions are not taken with respect to the intercompany advance.

Discussion
Section 7872 provides rules through which interest must be imputed on certain kinds of below market loans between defined classes of taxpayers. The category under Section 7872 closest to the facts of this case is the corporation-shareholder loan in which there is a loan between a corporation and one or more of its shareholders.

If Section 7872 applies, an amount of interest computed at the applicable federal rate (AFR, as defined under Section 1274) is deemed distributed/contributed between the corporation and the shareholder either as a corporate distribution or as a contribution to capital. Following the fictional distribution/contribution, interest at the applicable federal rate is paid by the borrower to the lender.

The below market, corporation-shareholder model does not directly fit the fact pattern set forth above; however, the statute and its legislative history make it clear the both direct loans as well as indirect loans are to be considered under Section 7872. Accordingly, it would be possible to argue that the loan between A and B is really a loan from A to TP followed by loan from TP to B. Then, Section 7872 would clearly apply. To my knowledge, such an issue has never been litigated.

In addition, the IRS has ample legal authority and a long history of using that authority to reclassify a transaction based on the government's own perception of its economic reality. This is called the substance-over-form doctrine. There is abundant case law involving advances between brother-sister corporations in which the IRS has asserted that the whole advance is a constructive dividend to the shareholder from the creditor corporation followed by a contribution to the capital of the debtor corporation. The IRS has been successful in some cases and unsuccessful in others.

It is my strongly held view that the taxpayers in this case should do everything possible to increase the probability that the advance between Corporations A and B will be viewed as a bona fide debt thus reducing the exposure to recharacterization attempts by the IRS. Accordingly, I suggest the following.

The advance should be evidenced by a written, legally valid, legally enforceable note bearing interest at a rate not less than the AFR. Interest under the note should be payable (and actually paid) no less often than quarterly, and I would very strongly prefer to see a definitive maturity date at sometime in the reasonably near future. As nearly as possible, this note should be identical to the terms on which Corporation B could borrow money from an unrelated lender.