On January 1, Year 1, a corporation lends $500,000 to a shareholder interest-free. The loan is a demand loan. The applicable federal rate (AFR) for Year 1 is 4%. The shareholder uses the funds for personal investment. What is the tax treatment of the imputed interest for the corporation in Year 1?

Answer options:

The corporation deducts $20,000 as interest expense.

The corporation recognizes $20,000 of interest income and a $20,000 compensation deduction.

The corporation recognizes $20,000 of interest income and treats the $20,000 deemed payment as a non-deductible dividend distribution.

No imputed interest is recognized because the loan is a demand loan.

How to approach this question

Identify the relationship between lender and borrower. Corporation-to-shareholder loans treat imputed interest as a dividend paid (not deductible) and interest income received (taxable).

Full Answer

C.The corporation recognizes $20,000 of interest income and treats the $20,000 deemed payment as a non-deductible dividend distribution.✓ Correct

Under IRC §7872, a below-market loan from a corporation to a shareholder is recharacterized. The foregone interest ($500,000 × 4% = $20,000) is treated as (1) a distribution of money (dividend) from the corporation to the shareholder, which is non-deductible to the corporation, and (2) a payment of interest from the shareholder to the corporation, which is taxable interest income to the corporation.

Common mistakes

Treating the deemed payment as compensation (deductible) instead of a dividend (non-deductible) when the borrower is a shareholder.

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