If you’ve ever thought about “getting creative” with compensation—like having your business loan you money at little or no interest—you’re not alone. It sounds harmless. It feels like a workaround.

But the IRS has already thought of it—and shut it down.

Welcome to the surprisingly aggressive world of below-market loans under Internal Revenue Code § 7872, where the IRS can impute income that you never actually received.

What Is a Below-Market Loan?

A below-market loan is exactly what it sounds like: a loan where the interest rate charged is less than the Applicable Federal Rate (AFR).

Under Treasury regulations, the IRS treats this as a disguised economic benefit—especially in employer-employee or shareholder-corporation contexts.

The Governing Rule

The statute provides:

“For purposes of this title, in the case of any below-market loan, the foregone interest shall be treated as—
(A) transferred from the lender to the borrower, and
(B) retransferred by the borrower to the lender as interest.”
— IRC § 7872(a)

This is where things get interesting—and dangerous.

How the IRS Recharacterizes the Transaction

The IRS essentially rewrites your deal into a two-step fiction:

1. Step 1: The lender gives the borrower “phantom cash” equal to the missing interest
2. Step 2: The borrower “pays” that same amount back as interest

Even though no money changed hands.

Result: Phantom Income

Depending on the relationship, that “phantom transfer” is treated as:

• Wages (employer → employee)
• Dividends (corporation → shareholder)
• Gifts (family context)

Real-World Example (Very Common)

Let’s say:

• Your S-corp loans you $200,000
• Interest rate charged: 0%
• AFR: 5%

The IRS will impute:

• $10,000 of annual interest income

Tax Consequences

• You (borrower):
  • May have $10,000 of wage or dividend income
• The business:
  • Must report corresponding compensation or distribution
  • May have payroll tax implications if treated as wages

And yes—this happens even if you never paid or received a dollar.

Why This Rule Exists (Policy Insight)

Without § 7872, taxpayers could:

• Avoid payroll taxes
• Convert compensation into non-taxable loans
• Shift wealth tax-efficiently

Congress shut this down by focusing on economic substance over form—a recurring theme throughout the Internal Revenue Code.

Exceptions You Should Know

Not every below-market loan triggers harsh treatment. Some key exceptions include:

1. De Minimis Loans

• Loans under $10,000 may be exempt
• BUT NOT if used to generate income (e.g., investments)

2. Compensation-Related Loans (Limited Relief)

• Some administrative exceptions apply
• Still risky if used aggressively

3. Gift Loans (Family Context)

• Subject to special imputation rules
• May involve gift tax considerations

Planning Pitfalls (Where People Mess This Up)

Here’s where I see this go sideways in practice:

• ❌ “It’s my company, I can loan myself money however I want”
• ❌ “We’ll just document it as a loan and skip interest”
• ❌ “It’s temporary, so it doesn’t matter”

The IRS doesn’t care. If it walks like compensation, it’s getting taxed like compensation.

Best Practices for Business Owners

If you’re going to structure loans:

• ✔ Charge at least the Applicable Federal Rate (AFR)
• ✔ Properly document loan terms (note, repayment schedule)
• ✔ Actually make payments
• ✔ Avoid “evergreen” loans that are never repaid

Strategic Insight: When Loans Still Make Sense

Despite the rules, loans can still be useful:

• Short-term liquidity planning
• Partner buy-ins or capital structuring
• Estate planning (when done correctly)

But they must be real loans, not disguised compensation.

Conclusion

IRC § 7872 is one of those provisions that quietly punishes “creative” tax planning.

It doesn’t prohibit below-market loans—it simply taxes them as if they were something else. And often, that “something else” is worse.

If you’re advising clients—or structuring your own finances—this is one of those rules that can turn a harmless idea into a tax problem overnight.

At Dino Tax Co, we help clients navigate tax matters ranging from unfiled returns to IRS letters and levies and everything in between with clarity and confidence. If you’d like guidance on your situation, schedule a consultation today. Call or text (713) 397-4678 or email davie@dinotaxco.com. We’re here to help you take the next step.