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Updated July 25, 2017
Related party loans are a great way to shift income and protect assets. Congress told the IRS to update its regulations to take into account credit risks of the related party. The IRS said “no”.
Shifting income to a lower tax entity is easy when using debt to transfer the income producing asset. The IRS required related party loan interest rate is below one percent regardless of the financial strength of the related party.
The flaw in the tax law is that all promissory notes have the same economic substance regardless of the credit worthiness of the borrower. The IRS requires an one percent interest rate on a long term unsecurred loan to a related party. Yes.. it is a sham rate and it is required. No need to look at the credit worthiness if the related party is a pass through entity (a trust, partnership or S-corporatoin).
