IRS, State Disagree on Loan Rates
QUESTION: In your Jan. 17 Money Talk, “Loans to Relatives Have Their Rules,” you described the Internal Revenue Service’s rules on interest rates to be charged for loans between relatives, friends or employees. You stated that the rates prescribed by the IRS are 12.37% for short-term loans and 13.37% for long-term loans.
It is my understanding that, in California, interest rates in excess of 10% on loans between individuals are deemed to be usurious. Penalties of treble damages can be assessed against such a lender. How do you resolve the apparent discrepancy between the two laws?--J.L.W.
ANSWER: You’ve thought of something the lawmakers didn’t. The section of the Tax Reform Act of 1984 that is designed to crack down on below-market loans made as tax dodges prescribed minimum interest rates with no regard whatsoever to state usury laws. As it now stands, a loan made at one of the prescribed federal rates could subject the lender to a substantial penalty under state usury laws or even be ruled unenforceable.
Tax lawyers have noticed the discrepancy, however, and have brought it to the attention of the IRS, which has yet to issue regulations for implementing this part of the 1984 tax act.
Until those regulations are issued, it won’t be clear how the IRS intends to deal with this apparent oversight of state regulatory power. All that IRS officials can say until then is that the new federal law doesn’t prohibit loans below the interest rates you stated; it just calls for individuals who don’t follow the rules to pay taxes on an amount equal to the difference between the prescribed interest rate and the rate charged by the lender. That hardly seems ideal.
There is another way to look at it, however. The IRS and the California attorney general’s office agree that, on federal tax returns, the federal law is binding whenever there is a discrepancy between state and federal law. Translation: Err on the side of the federal rates.
Viewed practically, “the likelihood of a D.A. (district attorney) bringing action against someone for following federal law instead of state law is so minimal it’s beyond existence,” said Herschel T. Elkins, an assistant California attorney general.
That is not to say it couldn’t happen, of course. It is easy to envision a case in which a parent lends money to an offspring under the dictates of the federal law, the two have a falling out and the offspring presses charges against the parent, citing state usury law violations.
Usury laws differ from state to state, but a rate ceiling of 9% or 10% is common, as is the exemption from these laws of such institutions as banks and savings and loans.
In California, the rate depends to some degree on the purpose of the loan. Money lent for normal household expenses--to help a teen-ager buy a car or newlyweds buy furniture, for example--cannot command a rate of more than 10% without being considered usurious under California law.
But money lent for investment purposes can command a slightly higher rate--five percentage points above the going discount rate. Since the discount rate--the rate banks charge one another for loans--currently is about 8%, individuals in California aren’t permitted to charge more than 13% on a loan to buy a house, for example.
Persons charging more than the state-prescribed maximum may be penalized by as much as treble the amount of the interest paid back. If they are found to have willfully broken the usury law, they are considered a loan shark, a felon, and may be imprisoned for up to five years.
Q. I owned a small amount of American Telephone & Telegraph Co. stock before the breakup of the Bell System. Rather than hold a share or two in each of the seven operating companies and the new AT&T;, I decided to take advantage of an AT&T; offer to swap my shares in the other companies in exchange for Pacific Telesis stock, which is the only Bell System holding I have now.
I can’t get an answer anywhere on how to handle this intra-Bell exchange on my tax return for last year. Can you help?--J.B.
A. You treat this situation just as you would had you instructed your broker to sell the stock in the “new” AT&T; and the Bell companies and buy Pacific Telesis stock with the proceeds. In essence, that is just what happened, except that your broker was AT&T.;
For tax purposes, declare as a capital gain or loss the cash that you would have received from the “sale” of your Bell System stock had you not instructed AT&T; to reinvest it in Pacific Telesis stock. (The same is true for cash that you received when AT&T; sold on your behalf the fractional shares in Bell System companies that resulted because shareholders received one share in each of the seven regional companies for every 10 shares of AT&T; owned. Holders with shares in increments other than 10 received cash instead of fractional shares. The proper treatment of this cash distribution was misstated in the Jan. 24 Money Talk.)
Figure the capital gain or loss by calculating the difference between the sales proceeds (even if you never actually received those proceeds but instructed AT&T; to reinvest them) and the post-divestiture cost basis for the shares sold. (You should have received by now a Form 1099-B from AT&T; showing your proceeds from the fractional shares and exchanges.)
The formula for calculating this new cost basis is provided by AT&T; in a booklet, “Divestiture Tax Information for AT&T; Shareowners,” which you should have received.
You will notice that there are two methods listed in that booklet for calculating the new cost basis, one preferred by AT&T; and the other by the IRS. The difference lies in the treatment of Pacific Telesis shares, part of which the IRS says should be considered a taxable dividend. (The amount in question is 39 cents per old AT&T; share or $3.90 per Pacific Telesis share.) AT&T; argues that the entire stock-swap transaction is tax-free.
Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Business Section, The Times, Times Mirror Square, Los Angeles 90053.
