Area I: Individual Compliance and Planning — CPA Practice Question 02

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Identify the relationship between lender and borrower. Corporation-to-shareholder loans treat imputed interest as a dividend paid (not deductible) and interest income received (taxable).

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C.The corporation recognizes $20,000 of interest income and treats the $20,000 deemed payment as a non-deductible dividend distribution.✓ Correct

C

Under IRC §7872, a below-market loan from a corporation to a shareholder is recharacterized. The foregone interest ($500,000 × 4% = $20,000) is treated as (1) a distribution of money (dividend) from the corporation to the shareholder, which is non-deductible to the corporation, and (2) a payment of interest from the shareholder to the corporation, which is taxable interest income to the corporation.

Common mistakes

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

On January 1, Year 1, a corporation lends $500,000 to a shareholder interest-free. The loan is a demand loan. The applicable federal rate (AFR) for Year 1 is 4%. The shareholder uses the funds for personal investment. What is the tax treatment of the imputed interest for the corporation in Year 1?

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Practice the full CPA TCP Practice Exam 3

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