A taxpayer has a $500,000 interest-free loan from their employer outstanding for the entire Year 1. The applicable federal rate (AFR) is 4%. The loan is compensation-related. The taxpayer has net investment income of $800. Which of the following correctly describes the tax consequences to the employee and employer for Year 1?

IRC §7872 governs below-market loans. For a compensation-related loan, the foregone interest ($500,000 x 4% = $20,000) is treated as a transfer from the employer to the employee (compensation income to employee, compensation deduction for employer) and a retransfer of interest from the employee to the employer (interest income to employer, potentially deductible interest expense for employee depending on use of funds).