Question

assume that Christiana loans $200,000 to Max, her son, to start a business (income- producing property). Christiana does not charge interest because Max needs the funds to operate a struggling startup business. Why should Christiana be required to pay tax on the interest she did not collect? On one hand, she received no interest income. On the other hand, interest would have been charged by Christiana in an arm's length loan made to any other borrower or by any other lender on a loan to Max. Christiana's choice not to charge interest is really an indirect gift to Max. Should Christiana be able to avoid tax on the income she assigned to Max? This type of income is sometimes referred to as "phantom" income.​

Answer 1

The IRS taxes Christiana on 'phantom' income from the interest-free loan to her son because it treats the forgone interest as income, which prevents tax avoidance through interest-free loans. This policy ensures that all economic benefits are subject to taxation, akin to taxing nominal gains without regard to inflation.

Step-by-step explanation:

The situation posed by Christiana lending $200,000 to her son Max without charging interest involves the concept of imputed interest and the U.S. tax implications for such a loan. According to the IRS rules, when a loan is given without interest or at a rate below the market rate, the government treats the forgone interest as if it were paid. This means that Christiana could be taxed on the interest she did not collect, which is a type of 'phantom' income. This policy prevents individuals from avoiding taxation through interest-free loans.

While Christiana might view the absence of interest as a gift to help his son's struggling startup, the IRS may view this as an attempt to transfer assets without paying applicable taxes. This is akin to other taxation principles where the government taxes certain economic gains or benefits despite there not being an actual cash transaction, such as a barter exchange.

Taxation on 'phantom' income like this prevents the use of loans as a method to perpetrate tax avoidance. In effect, Christiana is being taxed on the income she assigned to her son by not charging the interest that she would have in an arm's length transaction. This concept is consistent with the way the IRS may tax the nominal gains without an adjustment for inflation, causing taxable events even in cases where there is no real increase in economic wealth.