Interest Income Risk On Unpaid Related Party Loans
SUMMARY: If interest is not timely paid on related party indebtedness, the payee may need to report original interest discount income.
How often do you see or implement interest-bearing related party loans (e.g., among family members or between related corporations or other entities)? Pretty often, I’m sure.
How often do you see these loans not kept current? Not a rare occurrence.
How often do you see interest income picked up on the income tax return of the holder relating to unpaid interest income? Maybe not so much.
Such holders are running a significant risk of omitting an item from income.
On what theory? Most of these taxpayers are cash basis, not accrual basis, so their method of accounting should not be giving rise to income. Section 7872 requires imputed interest income on many of these loans, but not if they have adequate stated interest (even if that interest is not paid timely) – so if there is an adequate stated interest rate on the loan, Section 7872 should not apply.
That leaves us with the original issue discount (OID) rules, and therein is the problem. The OID rules are not the easiest to work with for those that don’t have regular exposure to them. Nonetheless, let’s go through it on a simple conceptual level to see why many commentators conclude OID arises on these loans when interest is not paid currently.
The OID rules effectively put a debt obligation holder on the accrual basis for interest that accrues on the debt. Here are the steps:
1. OID exists if the “stated redemption price at maturity” (SPRM) on a debt obligation exceeds the issue price.
2. The issue price is pretty simple – effectively what was received in exchange for the debt obligation. In a plain vanilla loan, it will be the principal amount paid to the borrower.
3. The SPRM is the sum of all payments due to be made at any time under the obligation, OTHER THAN FIXED AND PERIODICAL INTEREST PAYABLE IN ANNUAL OR LESS INSTALLMENTS (I.E., QUALIFIED STATED INTEREST, OR “QSI”). Treas. Regs. §1.1273-1(b). Assume we have $100 loaned, and a promissory note that requires $100 of principal repayments over the term of the note, along with monthly interest payments at or above the required applicable federal rate. There is no OID here, because the SPRM is the same $100 as the $100 issue price – the interest payments do NOT go into the SPRM figure because they are fixed and periodical and payable in annual or less installments.
4. The possibility of late or nonpayment of interest does not in and of itself create OID, so long as the interest is “unconditionally payable.” Treas. Regs. §1.1273-1(c)(ii). Interest is unconditionally payable if (a) reasonable legal remedies exist to compel timely payment, or (b) the debt instrument contains terms that make the likelihood of late or nonpayment a remote contingency. (a) above generally means that the holder can accelerate the debt and commence enforced collection action upon default, and (b) generally means that the penalty for nonpayment is so high that the debtor will have a strong incentive to stay current. Since most debt instruments will allow for acceleration and collection action after default (after a reasonable grace period), most such debt instruments with regular interest payments will not trigger OID.
5. The problem is that in determining whether interest is unconditionally payable, the loan default provisions are not taken into account if the lending transaction does not reflect arm’s length dealing and the holder does not intend to enforce the remedies or other terms and conditions. When the debt is between related parties, the question of arm’s length dealing probably always is a question, but that alone is not enough to find that the interest is not “unconditionally payable.” The second requirement of intent to enforce is a harder question to determine in advance. But once there is a default on an interest payment, if the holder does not impose the requisite harsh penalty or does not commence enforcement action, that would appear to be strong evidence of the holder’s intent not to enforce the remedies or other terms and conditions, at least at that time.
Thus it would appear that in related party loan situation, if the creditor defaults on an interest payment and the holder does not begin enforced collection action, that OID probably starts to accrue – either thereafter or possibly back to the commencement of the loan. Failure of the holder to report OID may subject the holder to penalties and interest on omitted income.
Perhaps the imposition of a significant monetary penalty on the payor for the late payment is enough to obviate the risk of OID under the provisions described under (b) under my discussion at 4. above without the need for the holder to commence enforced collection action. However, since there is still a question of intent to enforce, unless and until such penalty is actually collected it would appear the OID risk remains.
Note that the OID rules do not apply to all debt instruments, especially as to debt instruments issued in exchange for property – such instruments may be governed by other Code provisions such as Section 483.