Renewing Interest In Interest-free Loans

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The Internal Revenue Service keeps trying to put an end to the practice of companies making loans to employees and shareholders without charging interest, but it hasn't succeeded. In a recent case, the Tax Court ruled that an interest-free loan from a corporation to a shareholder or employee isn't a taxable dividend or taxable compensation.

The IRS and the Tax Court have wrangled over this issue since 1961, when the court held that an interest-free loan to a shareholder did not result in dividend income. The court reasoned that if the shareholder had interest income imputed to him for the amount of interest he didn't pay on the loan, he would be entitled to a deduction for interest payments of equal amount. Later court cases extended this logic. Nevertheless, the IRS has persisted in claiming that such loans constitute additional compensation.

In the latest case, Colin Beaton, a company president, owned 100% of the company's stock. He borrowed $123,000 interest-free from his corporation. The court ruled that there was no income for the borrower and suggested that the IRS cease pursuing cases in this area. If any changes are to be made, the court said, it is Congress that should make them.

You may not get the blessing of the IRS, but interest-free loans to stockholder/employees or other employees should be considered a viable tax-planning tool.