A taxpayer has a $500,000 interest-free loan from their employer outstanding for the entire Year 1. The applicable federal rate (AFR) is 4%. The loan is compensation-related. The taxpayer has net investment income of $800. Which of the following correctly describes the tax consequences to the employee and employer for Year 1?

Answer options:

Employee recognizes $0 income; Employer deducts $0.

Employee recognizes $20,000 interest income; Employer deducts $20,000 interest expense.

Employee recognizes $20,000 compensation income and $20,000 interest expense; Employer recognizes $20,000 interest income and deducts $20,000 compensation expense.

Employee recognizes $20,000 compensation income; Employer recognizes $0 income.

How to approach this question

Analyze the substance of the deemed transaction under IRC §7872: (1) Lender pays borrower (Compensation), (2) Borrower pays lender (Interest). Calculate the amount using the AFR.

Full Answer

C.Employee recognizes $20,000 compensation income and $20,000 interest expense; Employer recognizes $20,000 interest income and deducts $20,000 compensation expense.✓ Correct

IRC §7872 governs below-market loans. For a compensation-related loan, the foregone interest ($500,000 x 4% = $20,000) is treated as a transfer from the employer to the employee (compensation income to employee, compensation deduction for employer) and a retransfer of interest from the employee to the employer (interest income to employer, potentially deductible interest expense for employee depending on use of funds).

Common mistakes

Thinking the net effect is zero for both parties (it affects AGI and deductibility limits); confusing gift loan rules (net investment income limit) with compensation loan rules.

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