You can be taxed on “imputed interest” if you make an interest-free loan to a relative, or if you charge interest at less than the applicable federal rate (AFR) set by the IRS. If you do not charge interest equal to the applicable AFR, the interest that you do not charge is “imputed” to you by the IRS and taxed to you as interest income. Imputed interest rules also apply to low-or-no interest loans to an employee; the imputed amount is treated as interest to the employer and taxable compensation to the employee.
Many family loans are exempt from the imputed interest rules because of the $10,000 and $100,000 gift loan exceptions in the law. If your loans to another individual (total balance of all loans) do not exceed $10,000, and the loans are not used to purchase or carry income-producing securities, there is no imputed interest. Under the $100,000 exception, no interest is imputed if you make loans to an individual of up to $100,000 (total loan balance owed to you), the borrower’s net investment income for the year does not exceed $1,000, and tax avoidance is not a principal purpose of the arrangement. If the borrower’s net investment income exceeds $1,000, there is imputed interest, but it is limited to the borrower’s net investment income.
For loans to employees and shareholders, the imputed interest rules do not apply if the total amount of outstanding loans between the parties is $10,000 or less, provided tax avoidance is not a principal purpose of the loan. Certain job-relocation loans to employees also are exempt.
If the gift loan or employee loan exceptions do not apply, figuring imputed interest can get complicated, as the AFR that must be used to avoid imputed interest depends on whether the loan is payable on demand or a term loan, and for term loans, the length of the term. To simplify the computation, the IRS provides a “blended” rate that can be used for certain loans to relatives or employees that are payable on demand. The blended rate can only be used for a demand loan that has a fixed loan amount outstanding for the entire year. If the loan is not outstanding for the whole year, or the loan balance varies, the blended rate is not available and the regular AFR-based imputed interest computation applies.
For 2017, the blended rate is 1.09% (Revenue Ruling 2017-14). For example, assume a business makes an interest-free loan of $50,000 to an employee, payable on demand. If the $50,000 loan is outstanding for all of 2017, the imputed interest to the employer and the imputed amount of compensation to the employee for 2017 using the blended rate is $545 ($50,000 x 1.09%).