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Simple Versus Compound Interest

A taxpayer's business gets a line of credit from a related party (parents). Loan terms are 10% on simple interest, but if interest payments are not paid, under terms of the credit line the interest rate is increased to 16% and the interest changes from simple to compounding.

The business struggles for a few years and pays no interest at all on the loan. Finally business shows a profit and starts to make payments on the compounded interest.

Would IRS allow the change to compounding interest?

I understand IRS might not like a related party loan that charges more than

8%, but it's hard to see how the facts above benefited the lender, who effectively had no payments against their loan for years. And it is clear the lender had a very significant risk of losing their entire principal loaning to an unsuccessful business that was running losses. It's unlikely a bank would have made a similar extension of credit on a startup business with no collateral, and the terms of any credit card loan would have been far far worse than the terms extended here.

Just for purposes of argument, assume that the terms of the credit line do not run into any usury law problems in the state where the loan is made. I am interested in just the IRS issues related to the loan.

nish

Reply to
nish
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Why not?

Why would the IRS care? The 16% has to be reported as income on the related party's return, so the IRS gets their cut all the same. They might care if the entity making the interest payment is in a much higher tax bracket then the entity receiving the interest payment, but then again only if the amount is larger than a threshold. If the entity making the interest payment is in a lower tax bracket, then they ought to be sending you a thank you card.

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removeps-groups

I've not had time to research the upper end, but the IRS' interest lies in potential income shifting. Mom (retired 10% marginal rate) lends me (working, 33% in good years) money and if I pay her too high a rate, eyebrows get raised as this is just a way to shift money to her, and potentially evade taxes. It's the mirror image of me charging a relative too low an interest rate, which is also an IRS no-no. Joe

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JoeTaxpayer

What is the threshhold? Do you mean some absolute dollar amount per year?

nish

Reply to
nish

No idea. (I wrote this example to make things clear for myself: Let's you say the payer is in 35% tax bracket and receiver in 10%. If the payer pays 10k of interest, they save 3.5k. The receiver pays 10% or

1k. So the IRS has lost 2.5k.)

16% after missing a few years of interest does seem reasonable to me as they're getting compensated for 10% they should have got in the previous year, along with the interest on that 10%.

Also, the loans on prosper.com are in the range of 16%.

But I have no official experience in the matter.

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removeps-groups

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