Loans to Employees
What is a below-market loan?
A below-market loan is one that has an interest rate below the applicable federal rate. If the loan has no stated interest rate, it is also below-market. Applicable federal rates are published by the IRS each month in the Internal Revenue Bulletin and vary by maturity and type. Internal Revenue Bulletins are available on the IRS website. http://www.irs.gov/formspubs/index.html
What is the annual tax impact of a below-market loan to an employee?
For tax purposes, interest must be recognized annually on the amount of the loan at the stated rate. If there is no stated interest rate, or a below-market interest rate in the loan agreement, then interest must be calculated at the applicable federal rate. The difference between interest calculated at the applicable federal rate and the interest calculated at the stated rate (or zero if there is no stated rate) is taxable income to the employee (although the employee may, under certain circumstances, receive a deduction for “deemed” interest paid).
What is the tax effect when a loan is forgiven?
The forgiveness of any loan to an employee by Washington University is taxable compensation to the employee. The payment of the balance due of an employee’s loan by the University is taxable compensation to the employee. These payments are to be reported to payroll so that the applicable taxes can be withheld from the employee’s paychecks and income properly reported. The employee has the option to have the amount withheld from one paycheck or the remaining paychecks in the calendar year.
Accrued interest that is forgiven or paid by the University should also be added to the employee’s Form W-2 (Wage and Tax Statement) and tax should be withheld. The type and the amount of the loan will decide whether accrued interest must be computed and added to the Form W-2 at the time of the loan forgiveness.
Interest must be accrued on the amount of the loan at the stated rate. If there is no stated interest rate, or a below-market interest rate in the loan agreement, then interest must be accrued at the applicable Federal rate. Interest must be accrued from the date of inception through the date that the loan is forgiven if there has been no payments of interest made on the loan.
Are there any exceptions?
Exceptions to the interest accruals generally are:
- If the total amount of all loans to the employee are $10,000 or less and the avoidance of any Federal tax is not a principal purpose of such loans. For example the employee has outstanding student loans in the amount of $25,000 and a personal loan in the amount of $5,000. If the $5,000 is to be forgiven, the $5,000 and the accrued interest is added to the employee’s Form W-2 and the applicable taxes are withheld from future paychecks.
- A mortgage loan secured by a note on the new principal residence if the employee is eligible to deduct or exclude moving expenses. The note must state that the reduction of interest is contingent on substantial services being provided by the new employee.
- The loan is a bridge loan to a new employee eligible to deduct or exclude moving expenses and who uses the proceeds to buy a new principal residence and the loan is repaid upon the sale of the prior principal residence. The loan cannot be for more than the available equity (after prior encumbrance) in the prior residence. The loan is payable in full within 15 days of the sale of the principal residence.
Each exception is subject to detailed requirements.
Where is additional information?
Please contact the tax department at 314-935-8335 for help with below-market loans and loan forgiveness questions.
(updated Nov. 1, 2003)