Area I: Individual Compliance and Planning — CPA Practice Question 03

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Analyze the relationship between lender and borrower. Corp to Shareholder = Dividend. Corp to Employee = Compensation. Then apply the two-step deemed transaction: (1) Lender pays imputed amount to borrower (Dividend), (2) Borrower pays interest to lender (Interest Income).

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C.The corporation reports $20,000 of interest income and a non-deductible dividend distribution of $20,000.✓ Correct

The corporation reports $20,000 of interest income and a non-deductible dividend distribution of $20,000.

Under IRC §7872, a below-market loan between a corporation and a shareholder is treated as a corporation-shareholder loan. The foregone interest ($500,000 * 4% = $20,000) is treated as a dividend paid to the shareholder (non-deductible by corp) and interest income received by the corporation.

Common mistakes

Treating the deemed payment as compensation (deductible) instead of a dividend (non-deductible).

On January 1, Year 1, a corporation lends $500,000 to a shareholder at a 0% interest rate. The Applicable Federal Rate (AFR) is 4%. The loan is a demand loan. The shareholder uses the funds for personal investment. What are the tax consequences to the corporation in Year 1?

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