The Portable MBA in Finance and Accounting, 3rd Edition

Taxes and Business Decisions 329

right to offset loan repayments against future salary. The term of the loan
might even be accelerated should Brad leave the corporation’s employ.
This remarkable arrangement was fairly common until fairly recently.
Under current tax law, however, despite the fact that little or no interest passes
between Brad and the corporation, the IRS deems full market interest pay-
ments to have been made and further deems that said amount is returned to
Brad by his employer. Thus, each year, Brad is deemed to have made an inter-
est payment to the corporation for which he is entitled to no deduction. Then,
when the corporation is deemed to have returned the money to him, he real-
izes additional compensation on which he must pay tax. The corporation
realizes additional interest income but gets a compensating deduction for addi-
tional compensation paid (assuming it is not excessive when added to Brad’s
other compensation).
Moreover, the IRS has not reserved this treatment for employers and em-
ployees only. The same treatment is given to loans between corporations and
their shareholders and loans between family members. In the latter situation,
although there is no interest deduction for the donee, the deemed return of
the interest is a gift and is thus excluded from income. The donor receives in-
terest income and has no compensating deduction for the return gift. In fact, if
the interest amount is large enough, he may have incurred an additional gift tax
on the returned interest. The amount of income created for the donor, how-
ever, is limited to the donee’s investment income except in very large loans. In
the corporation/stockholder situation, the lender incurs interest income and
has no compensating deduction as its deemed return of the interest is charac-
terized as a dividend. Thus the IRS gets increased tax from both parties unless
the corporation has elected subchapter S (see Exhibit 11.4).
All may not be lost in this situation, however. Brad’s additional income tax
arises from the fact that there is no deduction allowable for interest paid on un-
secured personal loans. Interest remains deductible, however, in limited
amounts on loans secured by a mortgage on either of the taxpayer ’s principal or

EXHIBIT 11.4 Taxable interest.

Employer

Interest

income

Deductible

compensation

Nondeductible

interest

Taxable

compensation

Employee

Employer

Interest

income

Nondeductible

compensation

Nondeductible

interest

Dividend

income

Stockholder

Employer

Interest

income

Nondeductible

gift (gift tax)

Nondeductible

interest

Nontaxable

gift

Donee