The Taxation of Interest-Free Loans

Comment by Brien D. Ward

The lending of money interest free or at below-market rates historically occurred without tax consequences. In the 1960s, the Internal Revenue Service (Service) began to argue that interest-free loans ought to be taxed. In Dean v. Commissioner, the Service contended that since an interest-free loan did not require an interest payment, the borrower received the free use of the principal as an economic benefit that should be included in gross income. Initially, courts were not receptive to this position. Later, however, the United States Court of Claims adopted the Service's theory but was reversed on appeal. In 1984, the first significant breakthrough for the Service occurred in Dickman v. Commissioner. In this case, the Supreme Court held that the lender's right to receive interest is a ‘valuable property right,’ and that when such a right is transferred in the nature of a gift pursuant to an interest-free loan, it is subject to a gift tax.

The Dickman decision provided the impetus for full-blown reform in this area. In July 1984, Congress enacted section 7872 as a comprehensive set of rules to deal with interest-free loans. In drafting section 7872, Congress intended to close many of the loopholes that prior jurisprudence left open. To accomplish this goal, it created artificial transfers of interest between the lender and borrower. Congress designed these transfers to ensure that income was recognized by each party. Yet since section 7872 also affords the parties corresponding deductions in many circumstances, the transfers are often revenue neutral, the same result that occurred under pre-section-7872 cases. This result is ironic in light of Congress's announced intent to curb tax avoidance created by the use of interest-free loans.

In 1986, Congress again made a thorough revision of the tax laws. One of the most interesting changes was the elimination of the deduction for personal interest. Whereas under the prior law interest was deductible if ‘paid or accrued’ regardless of the character of the principal obligation, under the Tax Reform Act of 1986 (1986 Tax Act) only interest on certain types of obligations is deductible. The range of qualifying obligations is narrow under the 1986 Tax Act. The new law thus has an obvious effect on section 7872: artificial transfers will no longer produce tax-neutral results when the loan is compensatory.

Although critical commentary on the tax consequences of interest-free lending is already prolific, the 1986 Tax Act provides an appropriate occasion to reconsider the problematic issues. This Comment undertakes a theoretical and practical examination of the taxation of interest-free lending. Part I discusses the theoretical, but fundamental, issue of whether the interest foregone can be said to bestow an economic benefit on the lender or borrower. The issue will be addressed in light of economic theory without regard to the principles of tax law. Part II examines how the case law has treated the tax aspects of interest-free lending and how section 7872 has resolved the mercurial issues the jurisprudence has generated. Part III proposes a framework for the proper tax treatment of interest-free loans. Part IV concludes with a discussion of planning opportunities in view of the 1986 Tax Act. Specifically, the Comment emphasizes the potential scope of section 7872.


About the Author

Brien D. Ward.

Citation

61 Tul. L. Rev. 849 (1987)