Foregone Interest - Meaning and Examples
What is the Meaning of Foregone Interest?Foregone interest means the difference between the amount of interest you received on a loan you extended and the amount you could have received had you charged the going rate. That rate is usually based on the applicable federal interest rate or "AFR." In day-to-day examples, foregone interest exists any time you loan money to a friend or family member interest-free. Assuming a market-rate simple interest rate of 4%, if you loaned $100 to a friend for a year, you could have received $4. When you don't charge interest, $4 of interest income was foregone. Although there is a financial cost, personal goodwill was gained (hopefully). In the tax world, for example, foregone interest often comes up where the IRS wants to ascribe interest income on a loan, even where there is no or scant evidence the interest was actually paid. This is called "imputed interest" or, as I hear it from clients, "phantom interest."
Foregone Interest or Interest Forgiveness?A single transaction can often be defined many different ways depending on the intent of the parties. Because intent exists inside the mind, the IRS and courts will look to circumstantial evidence to determine the true intent. For exampled, the IRS has grounds to tax foregone interest even when the loan agreement is explicit as to no interest being charged in some circumstances (mainly business transactions) where there is a resulting, measurable, financial benefit to the party not paying interest and the transaction appears to result in a significant tax difference if recast in line with an arms-length transaction. As another example, below-market loans can be part of a compensation package to an employee. If the amount available is large enough to buy a home, for example, there is an argument that this is not meaningfully different, for tax purposes, than outright paying the interest for the employee. The IRS has fully explained this position in Publication 15-A, Employer's Supplemental Tax Guide, which states the following in the section titled Interest-Free and Below-Market-Interest-Rate Loans: In general, if an employer lends an employee more than $10,000 at an interest rate less than the current applicable federal rate (AFR), the difference between the interest paid and the interest that would be paid under the AFR is considered additional compensation to the employee. This rule applies to a loan of $10,000 or less if one of its principal purposes is the avoidance of federal tax. This additional compensation to the employee is subject to social security, Medicare, and FUTA taxes, but not to federal income tax withholding. Include it in compensation on Form W-2 (or Form 1099-MISC for an independent contractor). The AFR is established monthly and published by the IRS each month in the Internal Revenue Bulletin. You can get these rates by visiting IRS.gov and entering "AFR" in the search box. For more information, see section 7872 and its related regulations. But, if we were being complete, then there could be four tax consequences of this fiction: 1. Imputed income to the lender of the foregone interest payments;
2. Imputed income to the employee of the forgiveness/cancellation of the foregone interest payment (note, this does not result in a 1099-C or bad debt deduction because it is not the principal);
3. Imputed wage deduction to the employer (subject to W-2, withholding and employment taxes, etc.); and
4. An interest deduction to the recipient, if the loan was a mortgage loan or a business loan (or otherwise deductible in character). Foregone interest can also be treated as an imputed gift as defined under the federal estate and gift tax laws. There are potential gift tax (and, therefore, estate tax) consequences when the amount of the foregone interest exceeds the exemption or is part of a group of gifts exceeding the exemption, or is considered part of the estate because it is within three years of the date of a person's death.
ExceptionsThe IRS will not apply imputed income on foregone interest in some situations, including: Gift loans under $10,000, where the money was not used to buy income-producing assets (which comes up in relation to Form 656, for example).
Shareholder/Employee-Benefit loans under $10,000, if it can be shown that a tax avoidance purpose did not underlie the loan.
Loans "without significant tax effect" are also exempt. The IRS also provides examples of loans that are "without significant tax effect" in Publication 550, including certain employee-relocation loans, among others. Posted 2020/04/04 by Daniel Layton.