ExpertHard1 markMultiple Choice
CPA · Question 03 · Area I: Individual Compliance and Planning
On January 1, Year 1, a corporation lends $500,000 to a shareholder at a 0% interest rate. The Applicable Federal Rate (AFR) is 4%. The loan is a demand loan. The shareholder uses the funds for personal investment. What are the tax consequences to the corporation in Year 1?
On January 1, Year 1, a corporation lends $500,000 to a shareholder at a 0% interest rate. The Applicable Federal Rate (AFR) is 4%. The loan is a demand loan. The shareholder uses the funds for personal investment. What are the tax consequences to the corporation in Year 1?
Answer options:
A.
The corporation reports $20,000 of interest income and claims a $20,000 compensation deduction.
B.
The corporation reports no interest income because the rate is 0%.
C.
The corporation reports $20,000 of interest income and a non-deductible dividend distribution of $20,000.
D.
The corporation reports $20,000 of interest income and a $20,000 capital loss.
How to approach this question
Analyze the relationship between lender and borrower. Corp to Shareholder = Dividend. Corp to Employee = Compensation. Then apply the two-step deemed transaction: (1) Lender pays imputed amount to borrower (Dividend), (2) Borrower pays interest to lender (Interest Income).
Full Answer
C.The corporation reports $20,000 of interest income and a non-deductible dividend distribution of $20,000.✓ Correct
Under IRC §7872, a below-market loan between a corporation and a shareholder is treated as a corporation-shareholder loan. The foregone interest ($500,000 * 4% = $20,000) is treated as a dividend paid to the shareholder (non-deductible by corp) and interest income received by the corporation.
Common mistakes
Treating the deemed payment as compensation (deductible) instead of a dividend (non-deductible).
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