Karl is an employee of Cars-R-Us. As part of their employment agreement, Cars-R-Us loans Karl $1,000,000 interest-free to assist in the purchase of a car dealership. Assume the federal rate of interest is 8%. What is the tax treatment of the loan?
I.The arrangement has no tax consequences to Karl.
II.Cars-R-Us is deemed to have paid Karl compensation of $80,000.
III.Karl is deemed to have paid Cars-R-Us $80,000 of interest.
IV.Cars-R-Us' net income tax effect is zero due to this arrangement.

A)Only statement I is correct.
B)Only statements I, II, and IV are correct.
C)Only statement III is correct.
D)Only statements I, II, and III are correct.
E)Only statements II, III, and IV are correct.

Question

Karl is an employee of Cars-R-Us. As part of their employment agreement, Cars-R-Us loans Karl $1,000,000 interest-free to assist in the purchase of a car dealership. Assume the federal rate of interest is 8%. What is the tax treatment of the loan?
I.The arrangement has no tax consequences to Karl.
II.Cars-R-Us is deemed to have paid Karl compensation of $80,000.
III.Karl is deemed to have paid Cars-R-Us $80,000 of interest.
IV.Cars-R-Us' net income tax effect is zero due to this arrangement.
​
A)Only statement I is correct.
B)Only statements I, II, and IV are correct.
C)Only statement III is correct.
D)Only statements I, II, and III are correct.
E)Only statements II, III, and IV are correct.

Quizplus · Accepted Answer

The correct tax treatment involves recognizing imputed interest. Cars-R-Us is deemed to have paid Karl compensation equivalent to the interest that would have been earned at the federal rate (statement II), and Karl is deemed to have paid that interest back to Cars-R-Us (statement III). The net income tax effect for Cars-R-Us is zero because the deemed interest income is offset by the deemed interest expense (statement IV).

Karl Is an Employee of Cars-R-Us