Question

Wally is employed as an executive with Pay More Incorporated. To entice Wally to work for Pay More, the corporation loaned him $32,000 at the beginning of the year at a simple interest rate of 1 percent. Wally would have paid interest of $3,840 this year if the interest rate on the loan had been set at the prevailing federal interest rate.

a. Wally used the funds as a down payment on a speedboat and repaid the $32,000 loan (including $320 of interest) at year-end. Does this loan result in any income to either party, and if so, how much?

b. Assume instead that Pay More forgave the loan and interest on December 31. What amount of gross income does Wally recognize this year?

Answer 1

Requirement a:

A tax payer should include not only direct economic benefits like wages and interest but also realized indirect economic benefits from bargain purchases, below-market loans in his gross income.

The employer lender should report $3,840 as interest income consisting an actual interest income of $320 ($32,000 × 1%) and imputed interest income of $3,520 ($3,840 − $320) and he is allowed to deduct $3,520 as compensation expense. The employee-borrower should include imputed interest of $3,520 in his gross income as compensation and he is not allowed to deduct the imputed interest expense as he used the proceeds from the loan for personal purposes.

Requirement b:

The employee-borrower should include the following amount in his gross income

Particulars	Amount
Loan	$32,000
Actual interest ($32,000 × 1%)	$320
Imputed interest ($3,840 − $320)	$3,520
Total amount	$35,840