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Scorp shareholder loan interest

Technical topics regarding tax preparation.
15-May-2014 12:26pm
Client is a shareholder of a Corp and he borrowed a loan from it some years ago. He has been paying interest to the Corp based on the IRS Applicable Federal Rate (AFR) at the time when he first obtained the loan.

Because of the continuous drop of interest rate in recent years, the rate that he is paying now is way higher than the present IRS AFR. Therefore, he is hoping to reduce the interest rate of his loan too. He is the only shareholder of the Corp, it will be easy for him to reduce the rate. My question is:

(1) Is he allowed to do that?

(2) Even if allowed, is it advisable for him to do that though, such as would he get into problem with the IRS?

21-Apr-2014 9:31am
Western 'burbs of Chicago
Most of us do this annually, an annual, renewable note. So sure, do it. Do keep AFR + a smidge so you dodge the silly AFR rules. Add a 1/4% and you're free of some restrictions.....
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21-Apr-2014 9:28am
Most of us do this annually, an annual, renewable note.

From article in context of family loans:
15 See Blattmachr and Madden, ‘‘How Low Can You Go?’’ 109 J. of Tax’n 22 (2008), discussing the tax treatment when this oc- curs. For a contrary view see Hayes, ‘‘Adventures in Forgiveness and Forgetfulness: Intra-Family Loans for Beginners,’’ 13 Califor- nia Trusts and Estates Quarterly No. 2, 5 (2007). The complete analysis provided under the article by Philip J. Hayes is as fol- lows:
One factor indicating that a loan lacks bona fides is the exchange, during periods of falling interest rates, of a note for a new note with the same principal amount but bearing a lower interest rate. Some practitioners are un- concerned with refinancing an intra-family loan to a lower rate if the loan allows prepayment (almost all do, or, if silent, state law permits). More cautious advisors recommend avoiding this practice (see, e.g., Benjamin Feder, The Promissory Note Problem, 142 Trusts and Estates 10 (January 2003)), however, based on the plain economic reality that a true lender would not trade one asset for another less valuable. To avoid the IRS argu- ment that the loan is actually a gift, these advisors rec- ommend renegotiating the terms of the note to compen- sate the lender for the lower interest rate; perhaps by paying down the principal amount, shortening the matu- rity date, or adding more attractive collateral. The IRS has provided no direct authority on this issue. The Pro- posed Regulations include a section entitled ‘‘Treatment of Renegotiations,’’ (Prop. Treas. Regs. §1.7872-11(e)) but merely reserves the subject for later guidance, which has not been forthcoming. ... rticle.pdf

Sec 1274(d)
(3) Term of debt instrument
In determining the term of a debt instrument for purposes of this subsection, under regulations prescribed by the Secretary, there shall be taken into account options to renew or extend.

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