Partner loan

[natiro]

Partner makes a $300,000 loan to a partnership of which he has 50% interest. The loan is evidenced by a promissory note using the correct AFR. The loan is used for expansion and the partner expects to be paid back in full, including all interest. That said, the partnership did not make any payments to the partner during the tax year. The partnership is an accrual based taxpayer.

Is there a requirement that interest expense be recognized at the partnership level and income be reported to the partner even though no payments were made?

Would the answer be different if the partnership was a cash basis taxpayer?

If you can provide a cite for your opnion, that would be helpful, too. I've researched this before, but cannot seem to replicate what I thought I found at the time.

Thank you.

[Bees Knees]

IRS Pub 538, page 18 under the heading Expenses (accrual method) says:

Under an accrual method of accounting, you generally deduct
or capitalize a business expense when both the
following apply.
1) The all-events test has been met. The test is met
when:
a) All events have occurred that fix the fact of liabil-
ity, and
b) The liability can be determined with reasonable
accuracy.
2) Economic performance has occurred.

Later under the definition of economic performance, it says:

Interest. Economic performance occurs with the passage
of time (as the borrower uses, and the lender forgoes use
of, the lender’s money) rather than as payments are made.

So to answer your question, interest must be expensed over time under the accrual method even though the loan payments may be deferred. Under the cash method, interest is deducted at the time the loan payment is actually made.

[Corduroy Frog]

One Year

Natiro, I believe there is a generally accepted one-year period before it becomes necessary to impute interest. Interest must be imputed on a longer loan whether the interest is capitalized or deducted, and the same applies to the lender -- except the lender must declare interest income if an accrual basis taxpayer.

If lender is cash basis taxpayer, and interest has been imputed, then the first payment he receives must include this imputed interest, and the remainder of the payment (if any) is considered principle.

I don't know whether the one-year period is statutory, or whether it is just a general practice.

[Bees Knees]

correction

The accrual of interest does not apply if the partner reports the interest income under the cash method. In this case, the partnership cannot deduct the interest until the partner reports the interest in income [Section 267(a)(2)].

This same rule applies to S corporations and shareholders owning directly or indirectly more than 50% of the stock.

IRS Pub 541, page 6 says:

Payments by accrual basis partnership to
cash basis partner. A partnership that uses
an accrual method of accounting cannot deduct
any business expense owed to a cash basis
partner until the amount is paid. However, this
rule does not apply to guaranteed payments
made to a partner, which are generally deductible
when accrued.