Saturday April 20, 2024
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2.4.1 Interest-Free Loans
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Interest-Free Loans
Interest-Free Loans: The general rule on interest-free loans is that the interest is treated as a gift from the lender to the borrower.
Demand Note and Securities Issues: The most straightforward method for the loan is a simple demand note given by the charity to the donor/lender.
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Interest-Free Loans
The general rule on interest-free loans is that the interest is treated as a gift from the lender to the borrower. The lender is also treated as receiving the payment back from the borrower, thus producing taxable income to the lender. Sec. 7872. However, many donors to charities are interested in allowing charities to use funds interest free, so long as the donor could reacquire the funds if later needed. This interest-free loan allows the charity to invest the funds and use the earnings to fund the exempt purposes of the charity.
In order to enable these interest-free loans, the Service exercised its discretion in authoring regulations to create an exception that allows a donor to lend up to $250,000 to a charity. Reg. 1.7872-5T(b)(9). Since the regulation specifically refers to loans to "that organization," a donor could lend unlimited amounts to qualified charities, so long as the loan to any one charity does not exceed $250,000.
Demand Note and Securities Issues
The most straightforward method for the loan is a simple demand note given by the charity to the donor/lender. With the demand note the lender may require the charity to repay the note at any time. However, some demand notes have a notice requirement of 30 days. This allows the charity to convert securities to repay the note if requested.
While it is not required, many donors choose to bequeath the demand note to the charity at their death. In essence donors have made a revocable transfer of funds to the charity. However, in the event donors have a need for the funds, charity must return them upon demand.
If a charity has a significant number of demand notes, it should discuss the potential securities regulation issues with counsel. While one or a very few notes may not trigger securities regulation, a charity with a large number of demand notes may be entering into a series of transactions that could constitute a security. If a charity contemplates a large-scale program, it may be preferable to use revocable trusts rather than demand notes.
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Case Studies on Interest-Free Loans
A Charitable Buy-Sell Agreement:
Wayne and Nancy Allen started a small parts supply business over 30 years ago. Over the years the business, which is a C corporation, has grown substantially and now the enterprise is worth over several million dollars. Their son, Marcus, is very active in the business and currently owns 20% of the stock. Three years ago Wayne suffered a severe stroke and passed away shortly thereafter, leaving Nancy with ownership of 80% of the company. The company has very strong earnings and has a retained earnings problem. As was explained by their CPA, an annual penalty tax on "accumulated taxable income" can be imposed on certain corporations that accumulate earnings and profits in the form of liquid assets to avoid income tax to the shareholders. In other words, by permitting earnings and profits to accumulate inside the corporation instead of being distributed, as dividends, their corporation could become subject to this onerous tax. This tax is imposed in addition to other taxes, such as the regular corporate tax. Their CPA further stated that because of the substantial accumulation of retained earnings, the corporation is right on the borderline of being subject to this tax.
A Stadium, Charitable Trusts and a Family Legacy:
The Meyers family (three brothers, two sisters) inherited a sports complex from their parents 10 years ago. The sports complex consists primarily of a baseball stadium that seats about 7,500, complete with locker room and gym facilities. Each of the siblings inherited a 20% undivided interest in the complex and they have been successful in attracting various minor league baseball teams to play there during the baseball season. It has actually been quite a nice investment for them, generating substantial lease income during the season. However, each of the family members is now over 60 years old and they would like to consider selling the property.
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