Samantha is the president and sole shareholdr of toucan corp. she is paid an annual salary of $500,000, and her son, Aaron, the company’s chief financial officer, is paid a salary of $290,000. Aaron works for Tot1can on a part-time basis and spends most of his time training for triathlons. Toucan advances $85,000 to Samantha as an interest-free loan. What are the tax issues?

An interest-free loan is simply an advance where the borrower does not have to pay interest for a particular period of time.

According to the question, the Tax Issue here is that interest-free loans of money to friends and family may be considered a taxable gift for federal gift tax purposes under the United States tax code.

Explanation:

The United States Supreme Court in 1984  ruled that the interest-free use of money constitutes a gift for federal gift tax purposes. Thereafter, Congress approved a tax provision which reinforces this position.

When an interest-free term loan is given to a family member, the foregone interest is deemed an amount transferred from the lender to the borrower as a gift. The value of that gift is the difference between the amount loaned and the value of a loan for the loan period, and is computed using the applicable current interest rate.

For example, assuming the interest-free loan of $85,000 was given for a period of 3 years, the loan may be treated for tax purposes as an $80,000 loan and a $5,000 immediate taxable gift.

For income tax purposes, this $5,000 computed interest amount is then treated as transferred by the borrower to the lender as interest paid over the loan period. This second segment of the transaction will generate interest income to the lender. It may produce an interest expense deduction to the borrower, but the deductibility depends on the use of the borrowed funds. For example, if the Samantha as in the example uses the funds to start a business, the interest may be deducted as a business expense.

If the loan is considered a demand loan,that is, a loan that can be called for complete repayment at any time, the term of the loan is unknown.  Therefore, the interest income cannot be calculated over the life of the loan.  For demand loans, the gift value is considered transferred for each tax year during which the repayment demand is not made. The income tax effect is the same as a term loan: the lender in this  will have annual taxable income, and Samantha may have a tax deduction.

In either of these scenarios, the gift and income tax impact cannot be avoided by signing an interest-bearing loan and then forgiving the interest annually.

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