FROM: Robert D. Rynkar
DATE: August 11, 2013
SUBJECT: Related Parties Interest Income and Deduction
Two trusts, each with different beneficiaries, have been created by the same grantor. Trust A loans Trust B $1,000,000 to be repaid in a lump sum at the end of ten (10) years. The loan is evidenced by a written instrument which provides that interest must be paid in cash annually at the long-term AFR rate (currently 3.16%). Trust A and Trust B both utilize the cash basis method of accounting for tax purposes.
Trust B utilizes the loan proceeds to acquire commercial property which it rents at fair market rental to an unrelated party. Trust B lacks sufficient cash flow and does not pay the required interest during the first three (3) years of the loan.
(1) During the first three (3) years of the loan, is the interest which accrues under the terms of the loan, but has not been paid, included in the gross taxable income of Trust A?
(2) During this period, is the unpaid interest deductible by Trust B?
DISCUSSION OF LAW AND PROFESSIONAL COMMENTARY:
The determination of the answers to these questions depends on whether the ordinary rules of cash basis tax accounting apply, or is required inclusion/deductibility controlled by the special rules which apply to original interest discount (OID) (Code Secs. 1271 to 1275). Without the special OID rules, the interest would be includible by Trust A and deductible by Trust B only when paid. However, if any of the interest payable under the debt instrument governing this transaction is determined to be OID, the inclusion and deduction of that interest could be accelerated.
Code Sec. 1272, and the regulations thereunder, requires the current inclusion in gross income by the holder of a debt instrument of original interest discount (OID) on a pro-rata basis during the term of the loan, whether the holder is a cash or accrual basis taxpayer. The exceptions to the application of this section, which do not apply to our situation, are: (1) tax exempt obligations, (2) U.S. savings bonds, (3) short term obligations of not more than one year, (4) obligations issued before March 2, 1984, (5) certain loans between natural persons not exceeding $10,000 and (6) certain seller financed notes (Sec. 1272(a)(2); Sec. 1274(c)(3); Sec. 1274A(c). This section and the regulations thereunder also contain the detailed rules (not discussed here) for calculating the amount of interest to be included each year.
The key code section for purposes of the case at hand is Sec. 1273 which defines OID. Under this section, OID is defined as the excess of “stated redemption price at maturity” (SRPM) over “issue price”. (Sec. 1273(a)(1)). In applying this definition, however, “stated redemption price at maturity” (SRPM) has its own special definition: the sum of all payments provided by the debt instrument during and at the end of its term other than “qualified stated interest” (QSI) payments (Regs. 1.1273-1(b)). Therefore, if a debt instrument is not of the discounted type and the redemption price is the issue price, there would be no OID (and no acceleration of inclusion/deduction of interest) unless some or all of the interest under the instrument is not “qualified stated interest” (QSI).
The key definition, therefore, is the definition of “qualified stated interest” (QSI). Regs. 1.1273-1(c)(1)(i) defines “qualified stated interest” (QSI) as stated interest that is “unconditionally payable in cash or in property…… at least annually at a single fixed rate”. In the case at hand, the determinative words are “unconditionally payable”. The regulations provide that interest is unconditionally payable “only if reasonable legal remedies exist to compel timely payment or if the debt instrument (DI) otherwise provides terms and conditions that make the likelihood of late payment…. or non-payment a remote contingency…. “ (Regs. 1.1273-1 (c)1(ii)) (BNA 535, A-16). This regulation further provides that “remedies” and “other terms and conditions” are not taken into account (and, therefore, interest is not unconditionally payable”) if the lending transaction does not reflect arm’s length dealing and the holder does not intend to enforce such remedies.
With respect to the deduction of interest by the borrower, Code Sec. 163(e)(1) provides the general rule that the borrower, whether on the cash or accrual basis, can deduct the pro-rata portion of original issue discount (OID) applicable for a taxable year (based on the rules under Sec. 1272) (BNA 535.A-54(1)). However, in the case of debt instruments (DIs) issued in connection with the acquisition of personal use property, interest expense of cash basis taxpayers is deductible only when paid (Sec. 1275(b)(2); BNA 535, A-42). If the interest is not original issue discount (OID), the interest of the borrower is deductible under the normal tax accounting rules based on the cash or accrual method employed by the borrower.
Since the debt instrument in our case provides for the payment, at least annually, of fixed interest, the answer to Question #1 depends on whether the interest is “unconditionally payable” as defined in the regulations. If the interest is determined, under all the facts and circumstances, to be “unconditionally payable”, it would not be OID and it would be includible in gross income by Trust A only when paid (under the normal tax accounting rules for a cash basis taxpayer). However, under the circumstances involving related parties where interest is not actually being paid currently, it appears difficult to prevail in arguing that the lending transaction is at
“arm’s length” and that the lender “intends to enforce the remedies” for non-payment. If the Internal Revenue Service prevails on this point, interest would not qualify as “qualified stated interest” (QSI), thereby resulting in “original interest discount” (OID) which must be included in income currently by Trust A, whether or not actually paid. (This analysis is supported in an article by Steve Akers in which he states “…. in most intra-family loan situations where there are interest accruals, there will not be any “qualified stated interest” (Akers, Estate Planning Issues With Intra-Family Loans and Notes, August 2012, p. 8).)
The answer to this question depends on the final resolution of Question #1. If it is finally determined, as it appears likely, that the interest in this situation is “original issue discount” (OID), then Trust B would currently deduct the interest ratably under Code Sec. 163(e). (Note: Since the proceeds of the loan have been used by Trust B for a Code Sec. 212 activity entered into for profit, the exception to current deduction under Sec. 1275(b)(2) does not apply,) If it is determined that the interest is not OID, then Trust B could deduct the interest only when paid.