Officer or shareholder loans are common for privately held businesses. These loans need to be monitored closely to determine whether they are truly loans, or compensation, dividends, or contributions to equity. For a loan to be genuine, both the lender and the borrower must intend that the debt be repaid. There are a couple general requirements that “a loan should be treated like a loan”. A shareholder cannot simply “say” something was a loan. They actually need to treat it as one and the borrower has to have the ability to repay the loan.

Original Issue Discount refers to the excess of an obligation’s stated redemption price at maturity over its issue price, and it is taxable as interest over the life of the obligation on a year-by-year basis. It is effectively interest income. Those debt instruments that may have OID include zero coupon bonds, debentures, notes, certificates, or other evidence of indebtedness having a term of more than one year.

In 1984, the Tax Reform Act set provisions for applicable federal rates (AFRs). This is a minimum tax rate that must be charged on all loans, including personal loans. The IRS provides various prescribed rates for federal income tax purposes each month and TimeValue Software offers them on our website at Applicable Federal Rates | TimeValue Software.

There is a federal mandate for a business to charge interest on loans to or from its owners or for other related party loans. Sec. 7872 was enacted as part of the Tax Act of 1984. This Code section required loans between certain related parties, usually in excess of $10,000, to bear a minimum amount of interest based on the applicable federal rates (AFRs). With short-term rates well under 1%, the resulting amounts of self-charged interest can seem negligible but should be done.

The Rule of 78 is a method of allocating interest throughout the life of a loan. It is also known as sum-of-the-years-digits. The name comes from the way interest is allocated during a one-year loan. The Rule of 78 weights the earlier payments with more interest than the later payments, so twelve parts of the interest are allocated during the first month, eleven parts during the second month, ten parts during the third month, and so forth. During an entire year, there are 12+11+10+…+1 parts allocated or a total of 78 parts. Hence the name “Rule of 78.”