Company Provided Low-or-No Interest Loans to Employees
This has got to be one of the most used and yet misunderstood fringe benefits. Unfortunately, few companies are using this benefit correctly. However, you, my faithful subscribers, will not have this problem, since you will learn exactly what you need to do in order to make these loans tax-free.
The rules provided by Congress are entitled “Treatment of Loans with Below-Market Interest Rates.” These are defined as loans made to employees or even independent contractors at rates that are below the minimum rates allowed by the IRS, which are also known as the “applicable federal rates.” Thus, if you want to make the interest rates on these loans tax-free, there’s a minimum rate that you must charge or the employee is taxed on the foregone interest that he or she should have paid at the applicable federal rates.
Example: Alice borrows $50,000 from her corporation for a 10-year loan, interest-free. Because she didn’t pay interest equal to the applicable federal rate, she would be taxed on the foregone interest using this rate each year. Yuck!
Applicable Federal Rates
The IRS publishes the applicable federal rates each month. They’re available in your accountant’s office or you can call the IRS at 800 IRS-1040. (Isn’t that a cute number?) There are three federal rates:
- short-term rates, for loans of three years or less
- mid-term rates, for loans over three years but not over nine years
- long-term rates, for loans over nine years
Sandy’s note: You would determine how long you want the loan and find out the latest applicable federal rate for the duration of the loan that you want. As long as you charge at least that rate, you can get these below-market loans tax-free.
Also, as an estimate for you, the rate for long-term loans (over nine years) approximates the prime rate, while the rate for short-term loans is approximately one-half of the prime rate. Thus, the longer the duration, the more you must charge in interest.
Fabulous Exceptions to the Below-Market Loan Rules
- $10,000 de minimis exception: The below-market loan rules do not apply to loans of $10,000 or less, which means you can charge no or little interest.48 However, if the amount is above $10,000, the rules apply even if you pay down the debt below $10,000.
Example: You borrow $10,000 from your corporation, interest-free. This would be an exception to the rules and you would not pay any tax on the foregone interest.
Example: You borrow $15,000 from your corporation, interest-free. This would not be an exception even if you pay the loan down below $10,000. You’re taxed on each year’s foregone interest.
- Employee relocation mortgage loans made in connection with a new place of work: One fabulous exception would be to provide mortgage loans to employees as part of a transfer to a new location.50 Your new job location has to change so that you would qualify for the moving deduction. Generally, this means that your new job location should be on the other side of the city at least 50 miles away or, even better, in another city or another state. If you qualify, you can charge little or no interest.
The new workplace would have to be at such a distance from the employee’s old residence as to require at least an additional 50 miles of commute. In other words, if the distance between the new site and the old residence is at least 50 miles greater than the distance between the old site and the old residence, the distance requirement is fulfilled.
Sandy’s note: Hooray! Remember that I told you that we have good tax laws. You just have to know about them.
Requirements to Bullet-Proof Relocation Loans from the IRS
Nothing comes for free. To qualify, you must meet the following five easy tests:
- The loan can’t be for the purpose of avoiding taxes. This isn’t usually a problem unless, for example, only the owner of the company gets it and it isn’t provided to other relocating employees.
- The benefits of this loan aren’t transferable to a new buyer.
- The benefits of this loan are conditioned on continued future performance of substantial services by the employee. Thus, the loan agreement could provide that “if the employee ceases working for the company, the applicable federal rate of interest will be charged the employee” or that “the loan will terminate and must be paid off within six months of termination.”
- The employee must give a statement that the employee would itemize deductions on his or her tax return for each outstanding year. In other words, the employee would certify that he or she would be able to take a deduction for the interest on his or her federal tax return.
- The loan agreement provides that the mortgage money can be used only to buy a personal residence and cannot use the property as investment property. In short, you have to use the residence as your home and not rent it out.
Example: Karen works for the I’ve Been Moved Company (IBM). She is relocated from New York to California and the company provides a no-interest mortgage for 15 years. As long as she uses the mortgage for a principal residence, is required to work for the company in order to keep receiving this benefit, and certifies that she will itemize deductions (Schedule A) on her federal tax return, the foregone interest would be tax-free.
Sandy’s note: Any company of any size can offer this benefit to any employee of the company. Self-employed individuals are not employees, nor are independent contractors. This benefit is also very good for motivating and retaining an employee. What employees would want to leave a job if they were getting a tax-free mortgage that they would have to refinance at the going market interest rate if they quit?
I should note that this benefit is also available to corporate officers and to corporate owners as long as they are employees of the company.
- Bridge loans: If you don’t want to tie up your company’s money in a mortgage, you can provide no-interest or low-interest bridge loans, to hold an employee until he or she is able to get a permanent mortgage on the real estate. To make this benefit tax-free, you must meet not only all the criteria for mortgage loans but also the following three criteria:
- The loan agreement with the employee must provide that the employee must pay off the loan in full within 15 days after selling his or her principal residence.
- The total amount of all bridge loans must be less than the equity of the old house sold.
- The old house must be sold and not converted into investment property.
Sandy’s note: As you can see, making a tax-free temporary loan (bridge loan) is more complicated than simply providing a mortgage. However, you many not want to tie up company funds in a long-term, interest-free or low-interest commitment. Bridge loans are ideal in that they are short-term, temporary loans provided until the employee sells the former residence and has the funding to buy a new home. A corporation may provide bridge loans to the owner-stockholders. A sole proprietorship may provide them to employees—but not the owner!
The bottom line: In order to provide tax-free below-market loans, either you must charge what the applicable federal rate would be for your loan’s duration (which can be obtained from the IRS or your accountant) or you must meet one of the exceptions: loans of less than $10,000, relocation mortgage loans, or bridge loans. Make sure that you meet all the criteria noted in this book and you will bullet-proof this nice, tax-free fringe benefit from the IRS. It will also provide for much more loyal employees, because if they leave, this benefit can terminate.
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